Allowance for Loan and Lease Losses (ALLL) Overview By: Daniel R. Mc Donald Date: 12/3/09 To determine an appropriate level for the allowance, institutions must remain consistent over time during periods of economic stability and during periods of significant contraction or expansion. An institution may choose the appropriate FAS 114 measurement method on a loan-by-loan basis for an individually impaired loan, except for an impaired collateral-dependent loan. All other loans, including individually evaluated loans determined not to be impaired under FAS 114, should be included in a group of loans that is evaluated for impairment under FAS 5 method. There are steps that bankers can take to analyze and determine proper reserve levels in relation to asset quality.  Bankers are reminded that the level of the reserve, and the methodology determining the level, should be fluid and be directionally consistent, increasing during more difficult times and decreasing during better economic times.  FAS #5 For loans evaluated on a group basis under FAS 5, management should segment the loan portfolio by identifying risk characteristics that are common to groups of loans. Support for FAS 5 allowances must be based on qualitative or environmental factors. Management should consider such factors: Historical Losses (1) General categories (2) 1.    National and local economy 2.    Delinquencies and non-accruals 3.    Trends in volume and terms of loans 4.    Changes in underwriting, policies 5.    Experience and depth of lending management and staff 6.    Concentrations of credit 7.    Independent loan review results 8.    Overall problem loan levels It is important to note that management should maintain reasonable documentation to support which factors affected the analysis and the impact of those factors on the loss measurement. FAS #114 (3) An institution's ALLL methodology related to FAS 114 loans begins with the use of its normal loan review procedures to identify whether a loan is impaired as defined by the accounting standard.  For individually reviewed loans, how the amount of any impairment is determined and measured, including: Impaired loans – Three methods to determine impairment 1.    PV of expected future cash flow – e.g. unsecured debt 2.    Loan observable market value 3.    Collateral dependant Method        o MV – less              •   Holding costs              •   Selling costs              •   Other costs        o Adjusted MV – less              •   Loan amount        o Amount to reserve   The total ALLL should be (1) + (2) + (3) above – within a range of a +/- 5 percent error factor. It is important to note that the methods used to determine whether and how loans individually evaluated under FAS 114, but not considered individually impaired, should be grouped with other loans that share common characteristics for impairment evaluation under FAS 5. In addition, regulators will be scrutinizing these estimates as the industry continues to deal with the current credit crisis. With delinquencies and charge-offs escalating, the continued decline of residential real estate values, and increasing unemployment trends, it is critical that management have a well thought out strategy and approach for managing the ALLL. The challenge now comes from boosting reserves according to what instinct, common sense and experience all say is necessary, even as standard credit measures like past-due, criticized, and migration trends have yet to manifest the full impact of growing pressures on borrowers. The underlying foundation for the ALLL calculation (as it is for loan pricing, credit risk capital requirements, and other applications) is a bank’s risk grading system. The validity of the ALLL calculation hinges on the reliability and integrity of the risk grading assigned to individually-graded loans (such as Commercial & Industrial, Commercial Real Estate, Construction). This means not just a careful process of analysis and review at the inception of a loan, but also procedures to ensure that the grade is subsequently adjusted quickly and accurately in the event that creditworthiness changes over time. To the extent that downgrades are resisted, the reserve calculation will be understated.