Financial Lending Notes
Janauary 28, 2010

Analysis Options ALLL and the Financial Crisis

One consequence of the financial crisis has been increased regulatory scrutiny on how banks assess the adequacy of their Allowance for Loan and Lease Losses (ALLL). To help address regulators’ concerns, the Financial Accounting Standards Board (FASB) has issued an exposure draft of a proposed new standard for disclosures about the credit quality of financing receivables and the ALLL.

The proposed statement (Reference No. 1700-100) is intended to improve the transparency of financial reporting by requiring enhanced disclosures about a bank’s ALLL and the credit quality of its financing receivables. Its primary goal is to provide more information about the credit risk in a bank’s portfolio of financing receivables and how that risk is analyzed and assessed in arriving at the ALLL.

This statement aside, it’s critical for banks to structure a well-defined ALLL methodology that’s supported by adequate documentation and vetted by the board of directors.

In addition, someone independent of the process — often the head of loan review — should be responsible for regularly assessing the adequacy of the ALLL (at least quarterly or even as often as monthly) and ensuring the methodology was appropriately applied. In smaller community banks, this may be the senior lender or CFO, although an outside accounting firm can also perform this function.

Loss Ratios and Lookback Periods

Banks have experienced a significant increase in real estate losses in the past couple of years, making historical loss rates one part of the ALLL analysis that’s under enhanced scrutiny from regulators. The question: What is the appropriate lookback period for formulating the loss rates that should be used for determining ALLL adequacy?

Historically, banks have looked back between three and five years to determine their net charge-off ratios. Given the rate of real estate losses in the past couple of years, however, regulators are requiring some banks to shorten their lookback periods to as little as one year and sometimes even less.

Before the financial crisis, shortening the lookback period to even two years would have likely resulted in unrealistically low loss rates that didn’t reflect the true credit risk. Today, though, regulators often require short lookback periods specifically to help banks come up with more realistic loss rates. In many areas of the country, any data older than one year is practically irrelevant.

Regulators may also allow banks to lengthen their lookback period and assign more relevance to recent years. Still, no regulatory guidance exists to help banks decide on the appropriate lookback period for determining the adequacy of their ALLL.

As a result, the process is more art than science. You should have sound documentation that shows regulators how you arrived at your conclusions. Each bank is subject to the discretion of its particular regulator, so results and opinions will likely vary from one bank to the next.

Environmental Factors

Environmental factors should also play a central role in determining the adequacy of your ALLL. They will factor into assessing how estimated and historical losses may differ from each other. Primary environmental factors include unemployment figures; economic indicators; housing starts, sales and permits issued; absorption rates; and marketplace commentary.

Other elements that may impact your ALLL include:

• Changes in your bank’s lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses.
• Changes in the nature and volume of the loan portfolio and loan terms.
• Changes in the experience, ability and depth of bank management and other relevant lending staff.
• Changes in the volume and severity of past due loans, nonaccrual loans and adversely classified or graded loans.
• Changes in the quality of your bank’s loan review system.
• Changes in the value of underlying collateral for collateral-dependent loans.
• The existence and effect of any concentrations of credit and changes in the level of such concentrations.

Taking advantage of these factors, you may be able to reduce the amount of your ALLL. For example, have you gotten out of certain types of lending, like acquisition and development (A&D) or commercial real estate (CRE), or pared your concentrations in them? Have you rewritten loan policy or invested in lender training? Be prepared to substantiate and quantify the impact of these factors for regulators.

Including environmental factors in your ALLL analysis can help you answer the all-important question of whether the current risk in your portfolio will result in losses that are consistent with, lower than or higher than your historical losses.

See the Interagency Policy Statement on ALLL Methodology and Documentation for Banks and Savings Institutions (SR 01-17) for detailed guidelines on using environmental considerations in your ALLL examination.

Testing for Impairment

Impairment is another area to which regulators are paying especially close attention. If a loan that is collateral-dependent goes bad, your only option will be liquidation, so test loans for impairment early on.

But do you make a provision for the impairment or charge it off? For an impaired collateral-dependent loan, the regulatory agencies generally require a charge-off of any portion of the recorded investment in excess of the fair value of the collateral that can be identified as uncollectible. Estimated costs to sell also must be considered in the measurement of the ALLL under FAS 114 if these costs are expected to reduce the cash flow available to satisfy the loan.

As part of impairment testing, determine how volatile property values in your marketplace are. If they’re falling dramatically, a year-old appraisal may not be current enough. Finally, conduct a “reality test” by comparing your ALLL to your peer banks. For example, if your bank has a heavy concentration in A&D and CRE lending and you come up with an ALLL that’s less than your peer banks, your assessment of risk in your portfolio may not be realistic. If your ALLL deviates significantly from your peer banks, be prepared to justify this to regulators.

Note: In October, financial regulators released a Policy Statement on Prudent Commercial Real Estate Loan Workouts that provides guidance on what constitutes appropriate workout for a CRE loan.

The regulators believe that “prudent CRE loan workouts are often in the best interest of the financial institution and the borrower. [Therefore,] renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance.”

Do you wish to discuss more about increased regulatory scrutiny? Please contact our firm.