Allowance for Loan and
Lease Losses (ALLL)
Best Practices
Q&A
Q: What items should be included in FAS 5 Matrix?
The essential elements to be included in your FAS 5 calculation include: current loan portfolio data (can be imported from the core system); assessing and assigning weighted historical loss results; and deliberately assessing and
assigning key qualitative environmental factors by loan segment to adjust the analysis from its historical limitations to a current valuation assessment.
Q: What are the regulators looking for in supporting documentation for our FAS 5 calculations?
Based on our experience, to find alignment with regulator expectations, you will need to efficiently produce historical loss results and weight that history for appropriate relevance to your current situation for your FAS 5 analysis. Regulators are keenly focused on an institution’s ability to demonstrate a clearly defined, consistent method for
analyzing ALLL requirements, clear documentation of managerial decisions and reporting tools to support your process.
Q: Do you have suggestions for adjusting for peak loss years within the average?
One of the considerations we built into the WebEquity solution is to supplement the most likely loss expectations with lowest and highest expected exposures. This band of loss exposures are based upon the standard deviation to respect the peaks and volatility experienced in the historical losses. This is much more statistically valid than dealing simplistically with only the highest and lowest quarterly loan loss results – outliers are considered, but not over-weighted.
Q: Are we required to risk rate each individual loan?
Certainly, we must identify all of our impaired credits where it is probable that we will not collect all of our principal and interest as scheduled. Anything that falls into that category must be “risk rated”. However, we would suggest that high performance banks don’t wait for specific requirements for risk ratings –they risk rate all their credits. In theory, it may be possible for your risk ratings to be as simple as pass and impaired. Although, pass; special mention; substandard; doubtful and loss are traditional rating classes. For truly effective credit risk management practices these categories should be more rigorously differentiated with granularity displayed within the pass, criticized, and classified categories. From this type of risk rating you will typically observe a bell curve distribution which provides the basis for a great deal of credit risk analysis, including the critical issue of Allowance for Loan and Lease Losses.
Q: How do the regulators feel about the use of peer group historical loss data? Is it only acceptable in De Novo situation?
In our market analysis findings, the peer group data is very important. Yet, if you start out with only the “peer group answer” and then try to prove that you can duplicate the answer, you will end up with a credibility issue with your regulators. The reality is that the bank should work the process, which should include peer group comparisons, then make adjustments to pass the “smell test” afterward. This is a process that all the stakeholders will respect including
WebEquity Solutions hosted a complimentary Webinar for community banks on best practices in
Q: How much should be reserved for watch list and substandard not impaired customers?
It is clearly intuitive that more reserve for loan and lease losses should be established for credits that have a less favorable risk rating. The challenge is achieving a statistically valid approach to the use of historical loan loss results which arise from a portfolio that has credits which across a broad spectrum of risk ratings. The goal is to have a
dependable and justifiable reserve calculation that reflects the variance between the risk profile that generated the loss histories and the current risk profile. WebEquity continues to conduct research regarding the synthesis of historical loss data relevance and the portfolio’s transition regarding its risk rating profile. The goal is to display variances in the FAS 5 reserves by risk rating without disturbing the integrity of using the historical loss results.
Q: How do you justify a reserve when you have had virtually no losses over the past four years?
In this environment that result is outstanding and commendable. If you work the process we outlined in our recent Webinar, it may give you the ability to claim a lower-than-peer ALLL because you have the documentation to back up that it is appropriate, relevant, and justified. The important thing is to be able to tell your story with clarity and objectively using data to justify your position. This is very different than a simplistic claim that ‘the bank hasn’t seen
losses, so we wouldn’t expect to need to adjust our reserves’.
Q: What are some qualitative factors to look at besides economic conditions and historic losses?
The pertinent qualitative environment factors are those that impact credit losses on a local, regional, national or international level. Regulators identified nine considerations that are likely to cause estimated credit losses associated with an institution’s existing portfolio to differ from historical loss experience. The WebEquity ALLL system inserts the considerations cited by the FFIEC guidance as default factors to consider. However, the guidance clearly states that the considerations include, but are not limited, to these factors.
It would be appropriate to create more specific categories for external factors such as unemployment; deflation of asset values; obsolescence of resources/assets associated with specific industries; natural disasters; and government policy changes. We would caution you about having some unduly narrow definition of acceptable factors such as specific Federal Reserve statistics.
Q: What are the regulators looking for regarding specific environmental and economic factors for adjustments? We’ve listed declining real estate pricing, weakened job market, etc. and they ask for more.
There is no perfect or prescribed way to validate your subjective environmental factors. You must address your local, regional, and national markets. There are a multitude of factors that impact our credit losses and our reserve is intended to account for the individual and compounded impact of them all. If you are a regulator it makes sense that you will probe and push the question of a complete consideration of all relevant factors. The challenge is that there is no master set of variables to inventory and address. This is one of those situations where you must manage results and expectations. If you can show a robust analysis of environmental factors, you will be much closer to managing to regulator expectations than if you are asking regulators to tell you what environmental factors you need to address. Examiners are looking for competency more than exact completeness.
Q: Specifically what attribute(s) qualify a loan for completion of an impairment analysis on it?
The following link provides an excellent ALLL resource including: documentation of Supervisory Guidance, GAAP Guidance, list of common terminology, recommended examination steps to take when evaluating the ALLL, and ALLL Red Flags. http://www.frbsf.org/banking/audioconf/082007/allL_job_aid_2007.pdf
Q: Is there a simple formula to figure net present value (NPV) on future cash flows?
Q: How do specific allowances relate to general allowances and to the final ALLL?
Interpreting this as the general ratio between specific and general reserves – the key is to let the results be driven by the data. You may want to review this in a historical reference; however, we are unaware of any expectations or rules of thumb about the composition of the ALLL between specific and general allowances. It appears much more important that the analysis be consistently applied across all loan types and that you let the data results flow from the process and the analysis.
Q: What would be a good alternative calculation (simple) for determining the ALLL reserve?
This is the driving force behind having an automated tool. Even as we come out of this current credit loss environment into a situation with relatively less volatility, we never know when the next episode of credit risk volatility will occur. Having the sophistication of a tool like WebEquity ALLL is really a requirement of banking today. This may be one of those situations you can try to resist. But, resistance to automation might be futile, and it will enable you to put your productive energies into efforts where you can grow your bank and make more money.
Q: Can you speak to if there are any Safe Harbors?
Every time you hear the words “Enterprise Risk Management” you should think of the death of safe harbors. Bankers historically have their rules of thumb. As long as you keep this loan/deposit; this loan/collateral; this capital/assets; this interest spread – everything will be fine. Bankers, those days are gone. There is no ALLL safe harbor! The adequacy of your ALLL depends on your credit portfolio and the future credit risks. No simplistic short-cut calculation is adequate these days. Enterprise risk management is the opposite of safe harbors.
Q: Why is the ALLL Ratio of 1.50 to Loans the magical number especially if we have a history of low losses?
Q: When do the new regulation guidelines from GAAP take affect for banks of less than $600,000 million?
The response to this question below is taken from excerpts from FASB Update No. 2010-20 issued July 2010. For public entities, the disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. For nonpublic entities, the disclosures are effective for annual reporting periods ending on or after December 15, 2011.
The main objective in developing this Update is to provide financial statement users with greater transparency about an entity’s allowance for credit losses and the credit quality of its financing receivables. The objective of the amendments in this Update is for an entity to provide disclosures that facilitate financial statement users’ evaluation of the following: 1. The nature of credit risk inherent in the entity’s portfolio of financing receivables.
2. How that risk is analyzed and assessed in arriving at the allowance for credit losses 3. The changes and reasons for those changes in the allowance for credit losses.
The amendments in this Update enhance disclosures about the credit quality of financing receivables and the allowance for credit losses. Existing disclosure guidance is amended to require an entity to provide a greater level of disaggregated information about the credit quality of its financing receivables and its allowance for credit losses. In addition, the amendments in this Update require an entity to disclose credit quality indicators, past due information, and modifications of its financing receivables. These improvements will help financial statement users assess an entity’s credit risk exposures and its allowance for credit losses.
Q: Do you find that the regulators are always changing their mind (state says one thing, FDIC another)?
We find that regulators are working in a dynamic environment. In a dynamic environment, change is the norm – for bankers and regulators. This creates all the more reason to have tools in place that help your institution build a clear and justifiable ALLL.
Q: Please discuss ALLL within context of privately-held multi-charter banks that are less than $1B in assets.
The concepts are the same regardless of the size of the bank or the number of charters. The issue is the data management capability to aggregate information. You could argue that smaller banks are even more resource constrained, and therefore, in greater need of automation to help drive the efficiencies needed to keep up with regulatory compliance in today’s credit risk environment.
Q: How do you handle split classifications for “as is” and improved appraisal as far as classifications.
In the impairment analysis the format is flexible to value collateral. The framework of WebEquity ALLL does not prescribe or restrict the number of considerations in the calculations.
Q: When one is analyzing historical loan losses, what is the appropriate time period to use?
The historical period that most closely parallels the future. If you don’t know, the best way is to have a nimble system that allows management to rapidly assess various approaches and make adjustments on a timely basis as conditions dictate.
Q: What’s a good basis to assess the environmental factors?
Those conditions that impact your loan losses. The more highly correlated the better. Regulators expect your management and board of directors to actively assess the adequacy of your bank’s capital on a “forward looking” basis. To accomplish this, your bank must access how the future will likely be different than the present and past. These assessments are subjective and this accountability cannot effectively be delegated outside of the bank. The solution is not to buy a report – the solution is to explore the data and exercise judgment on an on-going basis about how global, national, regional, and local economic conditions may impact your portfolio’s net loan losses. Some good sources include: • NY Federal Reserve - National
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institutions and 20,000 lending professionals use WebEquity to automate and streamline their lending process and reduce operational costs, while making more uniform and profitable credit decisions. The company offers financial institutions a distinct advantage with a single solution that works for all loan types, an on-demand model that provides centralized, anywhere access, and the flexibility to configure the system so it fits their lending practices. WebEquity is endorsed by the Independent Community Bankers of America as the ICBA Preferred Service Provider for commercial lending software. For more information call 800-264-0787 or visit www.webequitysolutions.com.
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Q: How should a De Novo bank assess their ALLL?
Use loss histories of comparable banks in comparable markets. Business intelligence to mine the available data. History of Losses
• Own portfolio (Now/Past) • Own market (Now/Past) • Comparable market (Now/Past) • Industry statistics (Now/Past)
Q: How do you recommend that we handle unallocated excess reserves?
We have just gone through the largest credit crisis of our careers. If you find it impossible to legitimately justify your current reserves via: 1) historical loss weighting, 2) subjective/environmental/qualitative factors, 3) peer comparisons and 4) the highest potential exposure created by statistical deviations, we would be surprised and you should take a reverse provision. If your analysis shows that your reserve does not fit within the band of lowest to highest credit exposure, it is not justified and should be removed from ALLL. However, it would be quite surprising to find banks that could not legitimately support a wide-range of values with a thorough and insightful analysis and narrative.
View Webinar
See a recording of the “Automating Your ALLL Process” Webinar at www.webequitysolutions.com/webinars/library.
The answers in this document were prepared by:
