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Views: ALLL Best Practices: Keep the Appropriate Allowance for Loan and Lease Losses Reserve


Timothy A. Bosch , Salvatore Ciluffo
Wednesday, July 1, 2009

During these uncertain economic times, lenders must continually actively assess the quality of their loans. It seems like a simple statement; however, a bank can hurt itself without such diligence.

For example, many banks with high concentrations of commercial real estate loans have incurred extraordinary losses. Therefore, it is imperative to document the rationale behind all quantitative and qualitative factors, and be vigilant, proactive and realistic. Examiners will view favorably banks that are quick to self-identify problem assets and that apply a solid reserve against those loans that will likely result in some loss.

To help your institution explore the quality of your loans, pay attention to your allowances for loan and lease losses (ALLL). For several years, the banking industry enjoyed low loan loss rates. Normally, during periods of economic stability, most ALLL methodologies use a three- to five-year-average net loss history to determine the loss factors for the homogeneous loan pools for the Financial Accounting Standard (FAS) 5 portion of the ALLL. However, during periods of significant economic contraction—such as now—banks should adjust for their recent loss experience, which they should expect to more accurately estimate their inherent losses.

Accounting rules require consideration of external and internal factors affecting the adequacy of the ALLL. Banks should modify their qualitative and environmental factors to ensure that allowance estimates place appropriate emphasis on current market information and events in a bank's lending area:

  • External factors include the direction of national and local economies, changes in bankruptcy rates, changes in unemployment rates, and levels of national and local foreclosures.
  • Internal factors include asset quality trends, trends in nonperforming loans and charge-offs, portfolio concentrations, refinance risk, and the strength of the bank's credit administration practices.

Simply stated, examiners expect higher FAS 5 adjustments when the bank is experiencing larger losses and the economy is weak.

In addition, FAS 114 requires an individual credit impairment analysis. A loan is impaired if it's probable that all principal and interest payments will not be received according to the contractual terms of the loan agreement. Banks should define, in their loan policies, which loans will be tested for impairment, such as all loans over a certain size, all classified loans or all non-accrual loans.

Once the loan is determined to be impaired, the amount of the impairment needs to be measured using one of the three methods, the most common of which is fair value of collateral less selling and carrying costs. The challenge in today's economic environment is obtaining a realistic appraisal. Bank management is encouraged to maintain a FAS 114 analysis indicating the amount of impairment for each loan tested.

Don't hesitate to contact your examiners if you have questions on ALLL methodology.

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