Retail Lending Examination Procedures

Historical

Historical averaging is a rudimentary method for forecasting loss rates.

Management tracks historical charge-offs, adjusts for recent loss experience trends, and adds some qualitative recognition of current economic conditions or changes in portfolio mix. This method is highly judgmental and is used primarily by less sophisticated banks, or for stable, conservatively underwritten products. The most common of these products are residential mortgages when the collateral protection is conservative or the loans carry some sort of third-party guaranty or insurance.

The method is sometimes used for allowance purposes and monitoring general product or portfolio trends. The advantage is simplicity, and data needs are modest. Results can be reasonably accurate as long as underwriting standards remain relatively constant and economic or competitive conditions do not change markedly. The major limitation is that forecasts will lag underlying changes in portfolio quality if competitive or economic conditions change. The judgmental nature of the process also introduces potential bias by allowing forecasters to rely on longer run averages when conditions deteriorate and short-run trends at the earliest signs of recovery, either of which results in lower loss estimates. In addition, the method does not provide meaningful information on the effects of changes in product or customer mix, and it is difficult to apply any but the most basic stress tests.

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