How much should you segment FAS 5 (ASC 450-20) pools?

The extent of segmentation depends largely on portfolio size. The key to implementing successful segmentation processes is to be as granular as possible without losing statistical significance. You want a segmentation process that is granular enough to show pools of loans with similar characteristics, but you want to be sure the balances of the pools do not become so small that the impact of changing one variable overwhelmingly changes the outlook for the pool as a whole.

There is certainly room for improvement in many institutions’ segmentation practices. Prior to the Great Recession, the ALLL received little scrutiny, and the tendency was for financial institutions to use broad segmentation criteria. Still today, many institutions use Consumer, Real Estate, Commercial, etc. to segment their portfolios. Chuck Nwokocha, senior risk management consultant at Sageworks, believes that generality within segmentation is inadeqaute and recommends institutions use at least two levels of sub-segmentation.

Take for instance Commercial Real Estate (CRE). An institution could break out owner versus non-owner occupied; then assign a measurement attribute such as risk rating or risk grade. This methodology will not only grant institutions further insight into their portfolios, but it also gives them the capacity to graduate to migration analysis, which is largely viewed as a more robust form of analysis by examiners.

In conclusion, there is no “one size fits all” approach to segmenting an institution’s portfolio. However, many industry professionals believe that granular segmentation practices are largely underdeveloped in today’s banking landscape. Institutions that wish to bolster their ALLL and gain more insight into portfolio performance should examine their current segmentation practices and determine if there is room for improvement.