a story about competition between two banks working toward ...€¦ · mortgages, helocs and home...

A story about competition between two banks working toward CECL compliance

©2018 Fair Isaac Corporation. All rights reserved. 2


At your CECL start date, will you

have a strong start position?There are two different start dates for implementation of the new US GAAP current expected credit loss (CECL) model. SEC filers must begin complying with CECL in December 2019. All other public business entities have another year.

But the big difference between banks working toward CECL isn’t their start dates—it’s their start position.

Some banks will hit their start date in a much stronger competitive position as a result of how they’ve approached the compliance challenge.

Here’s a story of two banks taking different approaches. BestPrac Bank and BareMin Bank have home finance portfolios similar in size and account characteristics. Both have CECL-compliant forecasting and reporting processes in place by the implementation deadline.

Yet at the start date, BestPrac Bank has a lower impairment level than BareMin Bank. In the months that follow, their impairment levels and business performance diverge sharply. What’s going on?



Compliance day 1: sunny skiesBestPrac Bank is ready to estimate lifetime losses and hold reserves for all accounts. Big sigh of relief.

The company has expanded the number and types of data sources used for loss estimation to include both customer- and account-level scores, attributes and behaviors, as well as macroeconomic time series and forecasts. BestPrac Bank built component models for expected credit loss (ECL). As a result, it’s now able to estimate lifetime probability of default (PD), exposure at default (EAD) and loss given default (LGD) for all accounts and segments. The bank’s software rapidly performs ECL calculations, provides interactive tools for exploring impairment projections, and makes publishing MI and disclosures push-button easy.

BareMin Bank is ready to estimate lifetime losses and hold reserves for all accounts. Big sigh of relief.

BareMin Bank took a fairly coarse analytic approach, modeling ECL at the portfolio level.

The bank’s software streamlines forecasting and reporting, but provides little visibility into the “Why?” behind impairment forecasts.

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The Comply-Compete Gap

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Actions leading up to compliance day 1In the six months prior to the implementation deadline, BestPrac Bank ran new CECL provisioning and reporting processes in the background, parallel to existing processes. During this exercise, the bank improved its models, tested and refined its reporting and governance processes, and comprehensively assessed the financial impacts of CECL compliance.

Detailed outputs from the component ECL models and the software’s built-in dynamic reporting tools showed cost of capital for different segments, cohorts, vintages and products. Simulation revealed which parts of the portfolio would be most sensitive to economic stress. Bank analysts also used simulation to quickly run dozens of “What if?” scenarios to see if changing credit lifecycle decision strategies would reduce impairment. They were able to explore trade-offs with key drivers of portfolio performance under different economic conditions.

Clear, comparable information from this process made stakeholder meetings very productive. In addition, since BestPrac Bank had used the FICO® Score as one of the

inputs to its loss models, stakeholders were able to view segment-level impairment by this familiar metric. That helped participants with different perspectives—risk, finance, marketing, lines of business—quickly understand and discuss impairment and decision strategy choices.

BestPrac Bank took measures ahead of its CECL start date to minimize impairment. The bank refined its risk segmentation scheme and moderately tightened underwriting policies for mortgages, HELOCs and home improvement loans. It also reshaped its payment plan options and retrained staff to focus on pre-collections.

BareMin Bank ran in parallel for just two months, with the test focused on making sure the company could perform the calculations and produce the reports within the reporting timeframe. The bank made no changes to risk segmentation or decision strategies due to lack of both time and insight.




Compliance +6 months: clouds on the horizonBestPrac Bank is seeing a small, but significant, upward trend in impairment for some population segments in its home finance portfolio.

The investment in component ECL models continues to pay off. Analysts are able to see which loss drivers and which segments of the portfolio are most sensitive to pessimistic macroeconomic forecasts. At the same time, the bank has software with built-in reporting that reveals clear changes in portfolio mix and customer behaviors, which are also contributing to the month-over-month rise in impairment provision levels.

BareMin Bank is seeing little or no change in impairment for its home finance portfolios.

While the bank’s macroeconomic forecast is slightly more pessimistic, its portfolio-level impairment projection remains about the same. The bank is unaware of rising risk because its coarse approach to CECL modeling and reporting doesn’t reveal detailed changes to portfolio ECL dynamics.


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Actions at compliance +6 monthsHeeding these early warning signs, BestPrac Bank directs pre-collections treatments to accounts showing signs of rising risk even though they haven’t missed a payment. Intelligent, automated communications make contact in a discreet, low-friction manner at the best time through the best channel for each recipient. Accounts missing a payment are also targeted, except those predicted to self-cure. In anticipation of tougher times ahead, the bank also reassigns staff to increase focus on early-stage delinquencies.

BestPrac Bank slightly tightens underwriting rules for credit applicants with characteristics similar to existing customer segments showing sensitivity to macroeconomic change.

Using simulation software, the bank’s risk analysts estimate the benefits of these strategy adjustments. They explore trade-offs between how the strategy change is likely to impact revenue vs. delinquency, CECL provision and loss levels before deciding what to do.

BareMin Bank makes no changes to business as usual.



Compliance +12 months: getting choppy out thereThe increased losses BestPrac Bank’s models predicted six months ago have only partly materialized. Their full potential impact has been partly mitigated by the increased focus on pre-collections and early delinquency treatments and the tightening of underwriting strategies.

Even so, macroeconomic forecasts are projecting likely further deterioration. The bank’s CECL models are predicting higher losses across more product types and population segments.

The models are also showing the beginning of behavioral changes even in some lower-risk segments.

BareMin Bank is experiencing the full force of higher losses, which are not fully covered by the impairment provision levels set six months ago.

The bank knows, of course, that economic conditions have deteriorated and provisions must increase. What it doesn’t know is where in its portfolio most of the rising risk is coming from.


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Actions at compliance +12 monthsBestPrac Bank efficiently implements a series of wider adjustments to its operational decision strategies. Taking advantage of early warnings from its prior impairment estimates, the bank is able to prioritize operational resources ahead of time. These treatments focus on accounts where predicted lifetime value does not sufficiently offset the cost of loss reserves.

BestPrac Bank continues to broaden the range of customers receiving pre-collections payment reminders. At the same time, it steps up collections efforts on delinquent accounts.

The bank further revises underwriting rules for originating new accounts and offers a range of prices and product terms to reflect the variations in observed lifetime expected credit loss. Yet it keeps running carefully targeted low-rate promotions to improve portfolio mix and credit quality.

Using additional predictive models, optimization and simulation, the bank is able to understand where making decision strategy adjustments will reduce losses most while impacting revenue, attrition and customer lifetime value least.

Not sure where to focus mitigation efforts, BareMin Bank launches an analytic effort to try to uncover the root causes of rising loss projections. The process takes a bit of time since the bank doesn’t have granular data, component models or dynamic reports readily available. Staff who understand impairment dynamics are able to provide only limited support, as they are already struggling to manage their current, manual processes.

In the meantime, the bank tightens underwriting rules and stops all low-rate promotions. This may help reduce risk going forward, but it won’t change the fact that the bank has been booking new, higher-risk accounts for the past 12 months. What it will do, unfortunately, is hinder growth and limit profitability, as margins on the lowest-risk customers remain thin.

At this point, pre-collections treatments have a limited effect, since many accounts are already delinquent. To try to stem the tide, the bank unleashes aggressive collections treatments on all accounts that miss a payment.



Compliance +18 months: rough weatherThe economy is in a slump and losses continue to rise, but BestPrac Bank is weathering the downturn relatively well. Timely adjustments to pre-collections, collections and recovery strategies have kept losses under control. Cumulative effects of changes made to originations strategies over many months are beginning to reshape the portfolio as well.

The component CECL models and software continue to pinpoint areas of unexpected risk within the portfolio. The bank continues adjusting decision strategies to manage this exposure, while addressing pockets of growth opportunity that still exist.

BareMin Bank is in full defensive mode, with delinquency rates and balances rising fast. The bank is increasing spending on collections and recovery while tightening credit policies across the board to try to stem the tide of future losses.

While these broad-brush methods are reducing exposure going forward, they’re also having negative effects on business. Growth and profitability are suffering. Remaining portfolio accounts tend to be higher risk with fewer options for paying down their balance or taking their business elsewhere. As a result, the portfolio is shrinking and credit quality fails to improve as the bank had intended in taking these actions.


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Actions at compliance +18 monthsAs BestPrac Bank continues making incremental adjustments to decision strategies, it has the advantage of being able to operationalize these changes very quickly.

The bank’s CECL software combines data processing, calculation, decisioning, reporting and governance in a single engine. Credit risk analysts can nimbly maneuver from exploring forecasts at a very detailed level to simulating the effects of strategy changes. Loss drivers and trade-offs vs. other KPIs are clear for all stakeholders to see and discuss. Agreed-upon strategies are immediately exported to customer-facing systems and decision rules engines with no or minimal IT support.

BestPrac’s component models and agile software continue to enable it to identify pockets of relatively lower risk opportunity—including within higher risk populations—and rapidly bring to market products and offers that address the needs of these consumers.

BareMin Bank is entangled in a series of frustrating meetings about what to do next. Without clear visibility into what is actually happening at a granular level in the portfolio, stakeholders put forth function-specific views based more on anecdotal evidence and intuition than data and analysis, making it difficult to come to a consensus.

Even when a decision is finally made, implementation takes time, as IT has to recode policy rules in customer-facing systems.



Compliance +24 months: brighter skies aheadFinally, there are signs that the economy is starting to improve. BestPrac Bank impairment projections are now based on a slightly more optimistic forecast.

The company is ready to shift toward growth. Well-timed strategy adjustments over the previous 18 months have left the bank with a clean portfolio and the capital to invest in the future without encumbrances from the past. Carefully targeted treatments have helped customers manage their accounts during an economically stressful time, keeping satisfaction and loyalty high.

BareMin Bank is also forecasting economic improvement but can’t react quickly because it’s still in defensive mode, trying to manage large numbers of delinquencies. The business is focused on collections and recovery rather than growth. Many customers are unhappy with their experience with the bank.

Net Promoter Scores are dropping; attrition rates rising.


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Actions at compliance +24 monthsBestPrac Bank is one of the first to loosen underwriting policies and bring attractive rate specials back to the market. It is able to do this with confidence since component CECL models and dynamic reporting have helped the bank know exactly where to focus marketing resources.

Simulation helps the bank explore how more aggressive credit policies and new products would impact revenue, losses and capital consumption. Optimization recommends the best strategies for increasing growth while keeping losses under a specific threshold.

Because of their close and successful collaboration during the economic downturn, BestPrac Bank’s executives and portfolio managers have become quite adept at thinking about and discussing CECL provisioning and its drivers.

Most competitors aren’t able to move as quickly and surely, so BestPrac Bank captures much of the best business available in its markets.

BareMin Bank is not only still struggling to try to collect massive amounts of debt, it’s also struggling in the marketplace. The company is not in a position to be aggressive about rates or new products and services as they are unsure whether their current product structure, pricing models and decision strategies will lead to long-term profitability, especially if another economic downturn occurs in the near future.

With impairment provision levels at record levels, there’s very little capital available for investing in new digital services and other initiatives that could help the company compete for demanding low-risk consumers who are beginning to spend again.

BareMin Bank rapidly loses market share.



What made the competitive difference?At day 1, BestPrac Bank and BareMin Bank were both CECL compliant. They started out with similar portfolios and only slightly different impairment provisions. Both banks were compliant in their ability to calculate and report on actual impairment provision levels. So how did they end up at such different places 24 months after CECL start?

A key difference was that BestPrac Bank’s models were more accurate about responding to macroeconomic change and more granular at predicting its impact on portfolio mix and customer behavior. Like high-powered fog lights, they illuminated the nature and shape of what lay ahead.

Another important difference was that BestPrac Bank’s software gave the bank more agility to act on analytic insights without delay. Its software acted like highly responsive power steering for avoiding the worst hazards and staying on course.

And BestPrac Bank had another advantage, which grew over time…

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CECL compliance is making BestPrac Bank more competitive

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Decision strategy improvement and optimization

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During the timeline of our story, BestPrac Bank staff and stakeholders involved in complying with CECL were developing a more competitive frame of mind.

Month after month of working with models that provided an accurate, granular view of losses and customer behavior under volatile economic conditions naturally improved understanding of the portfolio and performance drivers. It also helped the company get a better handle on capital consumption in different parts of the portfolio as well as for proposed new products and promotions.

As a result, by the end of the story, BestPrac Bank is not only far ahead of BareMin Bank in terms of its current business performance, but also way out ahead in its ability to compete going forward.

Compliance plus competitive advantage— that’s a complete CECL solution.

a story about competition between two banks working toward ...€¦ · mortgages, helocs and home...

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