With 2022 in full swing, financial institutions that have put off looking for a solution to comply with the impending Current Expected Credit Loss (CECL) regulation deadlines are now in a time crunch to start aligning their processes. The macroeconomic environment continues to change at a rapid pace, and future predictability of loan losses and reserves must factor in these micro and macroeconomic forecasts rather than relying solely on historical loss rates.
There are many factors that weigh on financial institutions in today’s economic environment. They must maintain sufficient reserves while also allowing for a flexible strategic plan that maximizes market opportunities more proactively with market shifts.
Current lending trends across portfolios
In a recent webinar, TransUnion forecasts that the auto, credit card and personal loan markets will continue expanding into the non-prime segment of the market comprised of the subprime and near prime risk tiers as financial institutions recalibrate their growth strategies. Additionally, financial institutions are faced with increased competition from fintech organizations. With expansion deeper into the subprime and near prime risk tiers, financial institutions will have an increased need to evaluate loans and default probabilities with greater detail and more analytical agility to respond to both market conditions and borrower risk pool composition.
Mortgage purchase applications dropped 12% YOY in early 2022 as mortgage rates began to rise. This continued trend from 2021, along with consistently low inventory across most markets, is expected to attribute to an overall decline in mortgage originations in 2022 as compared to 2021 (Mortgage Bankers Association). Combined with the overarching increase in average origination loan balances, this leaves mortgage lenders with both a decreased pipeline and an increase in vulnerability for potential loss.
Delinquency market trend
Mortgage delinquency rates continued to drop in Q4 2021 finishing at a rate of 3.8%. Overall delinquency rates fell for all states as compared to 2020.
Forbearance programs under the CARES Act provided support to many borrowers during the most difficult months of the pandemic. Most of these programs are set to expire as borrowers are hitting the 18-month forbearance term limit. With this, hundreds of thousands of homeowners will need to either get current with their lender or risk defaulting on their loan and advancing to the foreclosure process. Lenders must be prepared for the impact of these impending expirations and are able to easily quantify the impact of future delinquencies on their portfolios and resulting reserve balances.
At the end of 2021, US unemployment rates continued to fall to new pandemic lows, both nationally and across 40 of the 52 states and territories. As of February 2022, national unemployment was approximately 3.8% with 14 states now having lower unemployment rates than prior to the pandemic. Inflation hit a 40-year high towards the end of 2021 as well, 7.0% from the prior year. Meanwhile, with entrepreneurship still booming, new business applications remained elevated across all regions anywhere from 32-54% above pre-pandemic levels. Real estate values continue to appreciate at historical rates while inventory shortages span most markets forcing lenders to compete on their ability to close loans in shorter timeframes and adjust lending capabilities quickly.
As the nation continues to recover from impacts due to the pandemic, naturally, each market’s total impact and recovery speed has varied. Some markets are recovering to pre-pandemic activity levels more quickly than others. Shifts in population distribution and migration have caused rapid swings in markets size and several key markets are severely impacted by mass migrations in or out.
Impact to strategic planning
The ability to forecast macroeconomic trends in conjunction with portfolio experience is key to maintaining strategic planning agility in today’s market. It is imperative for financial institutions to preserve a competitive edge to maintain pace with growing fintech organizations.
According to an Oliver Wyman study, CECL implementation will increase reserve requirements for nine out of every 10 banks, and the range of increase could be anywhere from 40% to 150%. Across various markets and macroeconomies, this increase will vary depending on product, maturity and risk mix with an even greater impact on those institutions expanding lending into the sub-prime and at-prime risk tiers. If the economy continues to be uncertain, the range of increase could result in a two to four times increase in reserve requirements.
Agility is key. To maintain a competitive edge and comply with new CECL regulations, financial institutions will have to have a firm grasp on their own internal portfolio performance and understand how these portfolios are impacted by micro and macroeconomic forecasts. Updating forecasts regularly and adjusting strategies accordingly will differentiate the winners and losers within their market.
While CECL implementation may seem daunting, it is crucial for financial institutions to evaluate the multiple implementation costs, including data acquisition and compilation, analysis tool implementation, review and audit resources and personnel costs for process change and education. Completing this evaluation may prove that a financial institution's current process or partner under the Allowance for Loan and Lease Losses (ALLL) methodology is no longer the most economically effective.
Key components to look for in an ECL/CECL solution
There are several key components to look for when evaluating a CECL solution. Whether building your own solution in-house or partnering with offerings in the market, financial institutions should be able to:
- Accurately assess the impact of macroeconomic uncertainty rather than the easy path of being conservative
- Assess the impact of mitigants of macroeconomic uncertainty such as widespread forbearance and income substitution due to government support and stimulus
- Dynamically adjust strategy as the economy unfolds
- Identify segments of growth by having a granular assessment
- Ability to continually assess market impact to credit loss reserves and proactively plan your product mix strategy
- Correctly identify resilient segments and capitalize on that resiliency
- Dive into reserves at a granular (loan) level to adjust forecasts dynamically