Loan Loss Reserve Adequacy And Methodology Revisited
Pat McElroy, President
Risk Management Partners, L.L.C.
Dallas, Texas
www.bank-expert.com
Although the new rules for determining the allowance for loan and lease losses (ALLL) were adopted in December of 2006, I have observed that many community banks have not yet revised their methodology procedures. Many banks have escaped regulatory criticism simply because they haven’t had an exam since the new rules were adopted. Other banks that did have exams during the first few months of 2007 were given a’“pass” and allowed more time to develop their new methodology procedures. The grace period has expired.
In this article, I will hit the highlights of the new ALLL methodology rules and cover the most common mistakes that I have observed that bankers are making. The new rules are covered in the Interagency Policy Statement on the Allowance for Loan and Lease Losses 12-06. (www.federalreserve.gov/newsevents/press/bcreg/20061213a.htm) This guidance is required reading for anyone involved in the process.
Specific Reserve Allocations
It is not acceptable to use an arbitrary percentage to establish a specific reserve on a classified loan, such as 20% for Substandard or 50% for Doubtful. Specific reserves may be established only on impaired loans and must be determined according to FAS 114. A loan is impaired when it is probable that the creditor will be unable to collect all amounts due (including interest and principal) according to the contractual terms of the loan agreement. This is a key point - if the loan is not impaired, you can’t assign a specific reserve to it. This is probably the most common mistake we see when evaluating ALLL methodologies in community banks. Many banks continue to use rule-of-thumb percentages to assign specific reserves to classified loans.
While there are three acceptable methods of determining a specific reserve under FAS 114, the most commonly used method is the “fair value of the collateral” method which must be used for collateral-dependent loans. The Interagency Guidance describes the other two methods and when their use is appropriate.
General Reserves
General reserves must be calculated according to FAS 5 for all loans that are not determined to be impaired. This includes non-impaired classified loans and all non-classified loans. FAS 5 reserves should be calculated for groups of loans with similar characteristics. For example, an historical net charge-off rate for commercial real estate loans could be applied to the current balance of commercial real estate loans to establish a starting point for determining the current estimated losses in that portfolio. The historical ratio should be adjusted by considering the “qualitative factors” that are likely to cause future loan losses to differ from historical losses. Yes, the old “qualitative factor” adjustment is still allowed under the new rules. As was the case before the new regulatory guidance, however, qualitative adjustments should be reasonable and clearly explained. Many banks do not apply the adjustments to all relevant loan groups and others do not adequately explain their qualitative adjustments.
Additional Points
The ALLL should not include reserves for off-balance sheet credit exposure such as off-balance sheet loan commitments or standby letters of credit. Such reserves, if appropriate, should be established in separate liability accounts. This rule is frequently violated.
The analysis and determination of the appropriate ALLL balance should be performed at least quarterly.
One final thought… Because of the current economic environment, the regulators are looking closely at loan loss reserve adequacy. They expect banks to maintain conservative and healthy reserves and they expect banks to adhere to the accounting rules that govern the determination of reserves. If you have not yet refined or tuned up your ALLL methodology, it’s time to do so.
About the authorL Pat McElroy Jr. has written for this publication and others and has spoken frequently on various regulatory topics. He can be contacted at 972/780-7049 or by email: pmcelroy@bank-expert.com.
