How do you calculate the growth or shrinkage rate for credit loss?

When calculating the growth or shrinkage rate for credit loss, the approach depends on the specific factors influencing the credit environment and the assumptions you make about future conditions. Based on the most helpful WSO content, here are some considerations:

1. Economic Conditions:

   • If the economy is improving, you might assume a lower credit loss rate due to better repayment capacity among borrowers. Conversely, in a deteriorating economy, you would project higher credit losses.
   • Historical data on credit loss rates during similar economic cycles can provide a baseline for your assumptions.

2. Sector-Specific Factors:

   • For example, in the case of banks, credit loss provisions are set aside based on anticipated defaults. These provisions are charged against the income statement during the period the loan is originated, not when the default occurs. This means you need to estimate future defaults based on current loan origination trends and economic forecasts.

3. Loan Portfolio Composition:

   • The type of loans (e.g., retail, credit card, mortgages, commercial) and their risk profiles will influence credit loss rates. For instance, credit cards might have higher default rates compared to secured loans like mortgages.

4. Market Trends:

   • Rising rents or other cost pressures could increase credit losses if they strain borrowers' ability to repay. Conversely, falling rents or costs might reduce credit losses.

5. Modeling Approach:

   • A common method involves projecting total loans outstanding as a percentage of GDP and adjusting for the bank's market share. However, this approach can be overly simplistic. A more nuanced model would incorporate macroeconomic indicators, historical loss rates, and stress testing under different scenarios.

6. Stress Testing and Sensitivity Analysis:

   • To decide on future credit loss rates, you can stress test your assumptions. For example, simulate scenarios where economic conditions worsen or improve, and observe the impact on credit losses.

In summary, determining the growth or shrinkage rate for credit loss involves analyzing economic conditions, loan portfolio characteristics, and market trends, while also incorporating stress testing to validate your assumptions.

Sources: Working in FIG (Financial Institutions Group) - An Overview., Working in FIG (Financial Institutions Group) - An Overview., How to measure risk, Multi-Family Acquisitions Excel Test, GP vs. LP Day