Benjamin Hoffman, KPMG
While many banks currently include consideration of a loss emergence period (LEP) in their ALLL estimation, or one other than a single year, auditors and regulators are putting more emphasis on its use. As losses decline, an LEP of more than a year can serve to maintain a higher allowance that is more consistent with the level of incurred losses in the institution’s portfolio.
The LEP represents the average time from the point at which a loss is incurred to the point at which the loss is confirmed, that is, the event that will lead to the loss and the charge-off date.
The LEP combines a pre-emergence or unobservable period, from when the loss event, such as a job loss, occurs to when the problem is discovered by the lender in terms of its impact on loan repayment, with the loss discovery period, which ends with the charge-off.
As the LEP serves as a multiplier on the allowance, extending it beyond a year (1x) can have a significant impact on the calculated ALLL estimate. And while the LEP will not be part of a process for estimating the ALLL under CECL, banks benefit from having a method to measure loss horizon as they move to measuring expected losses over the life of the loan in the proposed standard.
Regulators expect banks to have a formal process to support the LEP embedded in the ALLL, which would:
- Incorporate internal historical data where available and appropriate,
- Differentiate for portfolio risk characteristics in measuring the LEP,
- Have clear definitions for the discovery and loss confirmation events, and
- Refer to internal portfolio characteristics and external factors in estimating the preemergence period.
The LEP is typically measured using an empirical analysis of the time between individually identified trigger events and loss confirmation events for a sample or population of historical charge-offs. It is estimated using management’s judgment based on such items as loan monitoring practices and portfolio characteristics.