Migration analysis is a rigorous analytical process recommended by the regulatory agencies to determine financial institutions’ ALLL; yet it is underutilized. This type of analysis uses loan level attributes to track the movement of loans through the various loan classifications in order to estimate the percentage of losses likely to be incurred in a financial institution’s current portfolio.2 The purpose of migration analysis is to determine what rate of loss an institution has incurred on similarly criticized or past due loans.3 This purpose is the same as that of historical loss rate analysis, but it is more granular and therefore can give a truer reflection of the losses inherent in the current portfolio. For proper application, migration analysis requires extensive data collection and consistent, prudent risk rating methodology. The following outlines the problems and benefits of the migration analysis approach.

1. Pros and Cons of Migration
Analysis:
Ensuring a Proper ALLL Calculation
Ed Bayer
Regan Camp
Risk Management Consultants
Sageworks, Inc.
5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

2. Since January 2009, a total of 427 banks have failed in the U.S. As the global economic crisis drug
on, these institutions were ill-prepared to absorb the volume of loan and lease losses they were
forced to recognize. Consequently, regulatory agencies have increased pressure on the surviving
institutions to appropriately calculate adequate Allowances for Loan and Lease Losses (ALLL).
Specifically, determining the most appropriate ALLL methodology is a significant challenge
institutions face in calculating an adequate allowance. While regulatory guidance is scarce, latitude
is given to each institution to select the valuation methodology best suited for its own unique
characteristics and complexities. According to the Office of the Comptroller of the Currency (OCC),
multiple methodologies are accepted.
“The OCC does not require that banks use a specific method to determine historical
loss experience. The method a bank uses will depend to a large degree upon the
capabilities of its information systems. Acceptable methods range from a simple
average of the bank’s historical loss experience over a period of years, to more
complex migration analysis techniques.” 1
Migration analysis is a rigorous analytical process recommended by the regulatory agencies to
determine financial institutions’ ALLL; yet it is underutilized. This type of analysis uses loan level
attributes to track the movement of loans through the various loan classifications in order to
estimate the percentage of losses likely to be incurred in a financial institution’s current portfolio.2
The purpose of migration analysis is to determine what rate of loss an institution has incurred on
similarly criticized or past due loans.3 This purpose is the same as that of historical loss rate analysis,
but it is more granular and therefore can give a truer reflection of the losses inherent in the current
portfolio. For proper application, migration analysis requires extensive data collection and
consistent, prudent risk rating methodology. The following outlines the problems and benefits of
the migration analysis approach.
PROBLEMS OF MIGRATION ANALYSIS
Over time, information systems have changed exponentially due to numerous advancements in
technology. Cloud computing, dynamic coding, and web-based platforms are just a few examples
that have had a profound impact on information systems. Yet, despite these advancements, the
movement towards more sophisticated calculations of ALLL
provisions has actually diminished due to heavy reliance on
Microsoft Excel, a relatively weak and error-prone platform that is less
conducive to the complex nature of migration analysis. Whether through lack of knowledge or fear
of change, many financial institutions have not taken advantage of evolving information systems’
1
Comptroller’s Handbook: Allowance for Loan and Lease Losses; The Office of the Comptroller of the Currency;
th
June 1996 – May 1998; Guidance still applicable as of May 17 , 2012
2
Examination Handbook: Adequacy of Valuation Allowances; Office of Thrift Supervision; January 1994
3
Interagency Policy Statement on the Allowance for Loan and Lease Losses
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3. capabilities that make it possible for mid-sized and large banks to use migration analysis to
determine their ALLL provisions.
Migration analysis is not a process that fits for all institutions. There are several elements involved
in a true migration analysis, and they typically require a considerable amount of personnel, IT, and
data resources. If institutions don’t have the resources available, they may not be able to accurately
execute this more complex approach.
Additionally, for proper loan portfolio analysis using the migration technique, loan portfolios
should be first broken down into homogenous pools by similar attributes (Federal Call Codes,
geographic similarities, loan types, etc.) and then further broken down by risk classification (Pass,
Special Mention, Substandard, Doubtful) or delinquency ranges (0-29, 30-59, 60-89, 90+). When
broken down to this extent, an institution with a smaller loan portfolio may have inadequate
sample sizes to average out any anomalies that may be in each loan bucket. That can distort
calculated rates, thus failing to provide a proper ALLL provision. Often, it may be more appropriate
for these smaller institutions to use the more common historical loss rate method.
Access to historical data often presents barriers to the migration analysis method. The results of a
migration analysis rely heavily on high-quality historical data, an accurate historical loan risk rating
system, and other sound internal practices. The Office of Thrift Supervision’s Examination
Handbook explains, “An ineffective problem-loan identification, classification, or charge-off
system will materially distort historical net loss percentages and make migration analysis difficult
to apply.” The absence of quality data as the cornerstone of a migration analysis can result in
inaccurate results.
BENEFITS OF MIGRATION ANALYSIS
Migration analysis results in a more granular study of an institution’s portfolio due to the extensive
segmentation of the loan portfolio into several measurable buckets. This provides a more accurate
picture of how an existing portfolio would migrate to loss. Furthermore, as Neal Brauner of
Financial Services Advisory Partners, LLC notes, “Loan migrations across risk grades give insight
into portfolio loss characteristics and can drive pro forma projections.”
Though some financial institutions are fearful that migration analysis will increase a bank’s current
ALLL provisions, a proper analysis helps ensure adequate reserves. The OCC stated in March 1997,
“An understated ALLL expense will overstate the bank’s earnings
and can result in the violation of law.”4 This single statement makes it clear that a
proper ALLL provision isn’t a recommendation, but a necessity. If falsely calculated, whether
through mal intent, negligence, or error, the ALLL provision can have profound implications upon
the bank’s good standing and reputation in the eyes of public opinion and the law.
4
The Director’s Book: The Role Of The National Bank Director; The Office of the Comptroller of the Currency;
March 1997
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4. On the other hand, when circumstances dictate a decrease in provisions, migration analysis is the
most quantitatively rigorous and accurate method to justify such a decrease. The migration
method accounts for changes in composition of the credit portfolio and credit quality
deterioration. Its sophistication and accuracy is recognized by examiners, which reduces the risk of
regulatory criticism following a decrease in provisions.
COMPARISON OF TWO METHODS
While there is recognized variance in the application of migration analysis to an institution’s loan
portfolio, several components are applicable to every institution. Below is an example of migration
analysis looking at a bank’s C&I Pass, Special Mention, and Substandard rated loans. Remember, for
proper analysis we must further segment past the basic homogenous pool requirement, thereby
looking into the risk rating within each pool.
The example analyzes one historical period spanning eight quarters of the most recent available
data. Therefore, we start with the loan balance in the beginning of Q3 2010. Throughout the
migration analysis, we will only measure the net charge offs stemming from the beginning balance
amount in Q3 2010. Any increases to the loan portfolio balance will not be counted nor considered
for the calculation. Any net charge offs stemming from post Q3 2010 loan portfolio increases will
not be counted. The ending loan balance for the eight quarters is also not considered for our
calculation, only the beginning quarter loan balance and the net charge offs stemming from that
quarter’s loan portfolio.
Looking at the C&I Pass-rated loans in Q3 2010, we see a starting loan balance of $150 with no net
charge offs for that quarter. The following quarter (Q4 2010), our historical data indicates $2 was
charged off from the original $150, while our loan portfolio balance was increased by $5. The latter
is not important to our calculation, only the net charge off. As we complete the calculation of our
historical data across eight quarters, we conclude that $12 of net charge offs occurred across the
original $150 loan portfolio beginning in Q3 2010. Therefore, the ALLL provision rate for C&I Pass
loans is 8 percent as determined by migration analysis.
Migration Analysis
C&I - Pass Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Totals
Net Charge Offs 2 3 1 2 3 1 12 Migration
Starting Loan Balance 150 150 150 150 150 150 150 150 150 0.08
Additional Loan Balance 5 8 8 11 11 13 16
Additional Net Charge Offs 1 2 2 1 2 8
Ending Loan Balance 150 153 154 155 157 160 160 163 156.5
C&I - Special Mention (SM) Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Totals
Charge Offs 0.5 1 1 2 1.5 1 7 Migration
Starting Loan Balance 50 50 50 50 50 50 50 50 50 0.14
Additional Loan Balance 1 2 5 5 6 8 9
Additional Charge Offs 0.5 1.5 1 1 4
Ending Loan Balance 49.5 50 50.5 53.5 55 53 56.5 57 53.125
C&I - Substandard Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Totals
Charge Offs 2 2 1 1 2 1 9 Migration
Starting Loan Balance 25 25 25 25 25 25 25 25 25 0.36
Additional Loan Balance 1 1 2 4 4 6 7
Additional Charge Offs 1 2 1 4
Ending Loan Balance 25 24 24 25 29 26 29 30 26.5
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5. In comparison, below we use the same loan balances, quarters, and amounts for the historical loss rate
method as we did for migration analysis. The largest notable difference in this calculation is that we do
not further segment the homogenous pools into risk ratings. Instead, the historical loss rates are
calculated in sum formation of all risk ratings within the homogenous pools. Another difference in the
two calculations is the historical loss rate method uses the average loan portfolio balance across the
time horizon being measured. Therefore, the increases to the loan balance after Q3 2010 have an
impact on our calculations. Subsequently, we must count the additional net charges offs in the
calculation as well.
After completing our calculations of the eight quarters, the average loan balance totals $236.13 with a
total of $44 net charge offs ($28 net charge offs from the starting loan portfolio plus $16 of net charge
offs from additions to the loan portfolio). Our historical loss rate is calculated after annualizing the net
charge off to average loan balance ratio giving us a C&I loss rate of 9.32 percent.
Historical Loss Rate Analysis
C&I (Pass, SM, Substandard) Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Totals
Net Charge Offs 0.5 5 6 2 2 3 6.5 3 28
Starting Loan Balance 225 225 225 225 225 225 225 225 225
Additional Loan Balance 0 7 11 15 20 21 27 32
Additional Net Charge Offs 0 0 1.5 4.5 2 4 0 4 16
Ending Loan Balance 224.5 227 228.5 233.5 241 239 245.5 250 236.125
Total Net Charge Offs 44
Average Loan Balance 236.125
Historical Loss Rate (Annualized) 0.186342 /2 = .093171
Understanding the difference in the calculations is important to learning the application of migration
analysis, but
comprehending the impact of a more granular analysis
on an institution’s ALLL provision is most crucial in realizing the
benefits of migration analysis.
The following example compares these two calculations as applied to current loan balance in order to
calculate the institution’s proper ALLL provision for the next quarter in the C&I segment. Since the
migration analysis calculation required us to further segment the homogenous pools by risk rating, we
can also apply the loss rate to the risk rated pool balances. However, when we use the historical loss
rate we can only apply the loss rate to the sum of the C&I pool. We find significant differences between
the two ALLL provision calculations. As previously mentioned, using the migration analysis method often
leads to higher ALLL provisions yet is a more accurate forecast of trending loan conditions. A further
example of this is available at the right side of the table below, where we re-rate the C&I loan portfolio.
5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

6. Migration analysis adjusts the ALLL provision to reflect the conditions of the current portfolio, while the
historical loss rate method has no impact and ignores the new circumstances of our loan portfolio.
Migration Analysis vs Historical Loss Rate Method ALLL Provisions
Migration Analysis For ALLL Provision Using Current Balances Using Re-Structured Ratings
C&I - Pass 163 0.08 13.04 183 0.08 14.64
C&I - Special Mention 57 0.14 7.98 57 0.14 7.98
C&I - Substandard 30 0.36 10.8 10 0.36 3.6
Total ALLL Provision 31.82 26.22
Historical Loss Rate Analysis For ALLL Provision Using Current Balances Using Re-Structured Ratings
C&I 250 0.093171 23.29275 250 0.093171 23.29275
Total ALLL Provision 23.29275 23.29275
With the advancements in cloud computing and the continual development of web-based platforms,
secure Software as a Service (SaaS) applications allow financial institutions to perform migration analysis
accurately without the limitations of a bank’s information system, the previous high labor requirement,
and the potential for user error tied to manual entry. Migration analysis is a technique that institutions
should consider integrating into their ALLL methodology to provide the most accurate ALLL provision
calculations.
5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

7. About the Authors
Ed Bayer is a Risk Management Consultant at Sageworks, where he serves as a specialist in assisting
financial institutions with accurately interpreting and applying federal accounting guidance. Ed’s primary
focus is allowance for loan and lease loss provisions (ALLL) and stress testing loan portfolios. Before
joining Sageworks, he acted as president for a private holding company where he focused on new
business acquisitions, valuation models, federal taxation, and subsidiary business structures. Prior to
that, Ed served as a Financial Consultant with Merrill Lynch, graduating from their Path of Achievement
program. He received his MBA with concentrations in strategy and entrepreneurship from Vanderbilt
University’s Owen Graduate School of Management, where he was a CLARCOR Scholarship Recipient,
and he received his bachelor’s degree from the University of Tennessee.
Regan Camp is Risk Management Consultant at Sageworks, where he serves as a specialist in assisting
financial institutions with accurately interpreting and applying federal accounting guidance. Regan
focuses on the allowance for loan and lease loss provisions (ALLL) and stress testing loan portfolios. Prior
to joining Sageworks, Regan served as a Project Manager and Senior Consultant at Dittrich & Associates
LLC, where he assisted financial institutions in the administration of FDIC Loss Share Agreements, the
establishment of special asset divisions, and the resolution of troubled portfolios. Prior to joining
Dittrich, he worked at Deloitte and Touche, L.P. as a Senior Consultant and Asset Manager. Regan
received his bachelor’s degree from Brigham Young University’s Marriott School of Business, where he
studied business management and finance.
5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com