Consider: “The allowance for loan and lease losses represents one of the most significant estimates in an institution’s financial statements and regulatory reports.” — The Interagency Policy Statement on the Allowance for Loan and Lease Losses – December 2006
Consider: “Examiners will continue to evaluate the effectiveness of an institution’s loss mitigation strategies for loans as part of their assessment of the institution’s overall financial condition.” — FDIC Financial Institution Letter #43-2009 – August 2009
Consider: “As of the third quarter 2009, only 60 percent of U.S. banks had loan-loss reserves determined adequate to cover the inherent risk in their loan portfolios.” — FDIC examiner – March 2010
No one has to tell a banker that the screws have tightened, that the next federal examiner to enter the bank is going to scrutinize the loan portfolio more closely than the previous one. Or that the examination will focus on whether the bank has designated adequate reserves to cover the loss risk in its portfolio. Still, examiners tell us that loan-loss reserves lag behind loss estimations — and the majority of enforcement actions cite the ALLL for correction.
So how can the bank be prepared? Most important is implementing a policy and process to determine ALLL that is based on a comprehensive, well-documented and consistently applied analysis of the loan portfolio. That includes having adequate data capture and reporting systems to support and document the analyses, and to evaluate the bank’s loss potential and subsequently its loan-loss allowance. The bank can be certain that the examiner will look to see if management’s analysis is reasonable, supported by reliable evidence and inclusive of all relevant factors. The key to a successful examination, then, is to have a policy and process and be able to verify the efficacy of both.
While such generalizations may provide direction, they leave room for a great deal of subjectivity in an examiner’s review — a wide range of estimates is possible due to a long list of factors under consideration. Beyond its best efforts to establish a policy and practice, what steps can a bank take to avoid a problematic examination and the subsequent consequences? FDIC examiners tell us banks would do well to avoid the following common mistakes, the factors they encounter most frequently in their examinations today.
Mistakes in Policy
Common Mistake #1. Failure to include adequate description of responsibilities of participants in ALLL process. In the document that defines your policy, include the names and responsibilities of everyone in the bank who takes part in the ALLL determination process and define their roles. That includes the role of the board of directors, which is responsible for ensuring controls are in place and management has a reliable, consistently applied process, and that documentation is appropriate and maintained.
Common Mistake #2. Failure to describe ALLL methodology adequately. Banks often do not provide sufficient detail in their descriptions of policy to satisfy today’s closer looks. Your description should include not only a breakdown of loss attribution by pool, but also go deeper, by category of loan — construction, residential, auto. Your policy statement should also include such detail as how you are determining historical loss ratios and the internal and external factors impacting loss ratios, as well as what those factors are and the related allocations used from period to period.
Common Mistake #3. Failure to indicate board responsibility for regular review and approval of ALLL policy and process. Include reference to the schedule that the board adheres to in reviewing policy and process and approving them as adequate and reliable for determining ALLL. While an annual review was previously considered adequate, today’s boards should review policy and process for reliability on a quarterly basis. The board’s role and expertise in this area are critical. Some examiners are going as far as to tell banks to restructure their boards.
Mistakes Relative to FAS 114 (Impaired) Loans
Common Mistake #1. Failure to include “materiality” as a selection criterion. “Pass” loans should be included in the analyses, despite the fact that, by definition, they present no inherent risk. Heed the warning contained in the OCC Comptrollers Handbook: “ ... even in banks with loan review systems that generally provide timely problem loan identification, a lack of information or misjudgment will sometimes result in a failure to recognize adverse developments affecting a pass credit.” Essentially, the bank must be able to demonstrate its good loans are actually good.
Common Mistake #2. Failure to maintain a list of loans selected for review under FAS 114. Each loan categorized as impaired should be supported minimally by bulleted information detailing the reviewer’s reasons for deciding the loan is impaired. The completed FAS 114 report should be readily available for examination.
Common Mistake #3. Failure to support the method chosen for impairment calculation as the most appropriate. If the loan is collateral dependent, use the “fair value of collateral” method. If not, but payments are being received, use the “discounted cash flow” or “observable market price” method, whichever is most appropriate.
Common Mistake #4. Failure to include Troubled Debt Restructure loans as impaired. Loans where terms have been modified under FDIC programs or guidelines as TDR should be pooled and included as a pool category. Typically, “1-4 family” residential loans are exempt from FAS 114, but not where a TDR is involved.
Common Mistake #5. Using outdated appraisals or evaluations. The bank must develop and document criteria for reappraising and re-evaluating as part of its overall program to review and monitor portfolio risk. Specifically, examiners are required to review the bank’s process for monitoring real estate values.
Common Mistake #6. Unsupported adjustments to valuations. The bank must have, and be able to explain and justify, a clear policy for applying discounts to reflect changes in the market or other factors as it updates appraised real estate values.
Common Mistake #7. Failure to include relevant factors in the cost of selling collateral for collateral-dependent loans. In determining the actual revenue from the sale of collateral securing a loan, the bank must consider cost factors, including the holding period before selling, cost of maintaining the collateral during that time, the discount the bank will have to offer, the selling cost and other factors affecting the realizable value of the collateral.
Common Mistake #8. Using tax values as the valuation source. As opposed to valuations from local agencies for tax purposes, FAS 157, the accounting standard for determining fair values, defines fair value in terms of the price in an orderly transaction between market participants for the sale of an asset or transfer of a liability in the principal market for the asset or liability.
Common Mistake #9. Failure to address junior liens in calculations. The recent FDIC directive, FIL-43-2009, states: “The need to consider all significant factors that affect collectability is especially important for loans secured by junior liens on 1-4 family residential properties areas where there have been declines in the value of such properties.”
Junior liens should be pooled categorically, as are other loans, the document continues: “After determining the appropriate historical loss rate for each group of junior lien loans with similar risk characteristics, management should consider those current qualitative or environmental factors that are likely to cause ... credit losses ... (that) differ from the group’s historical loss experience. ... Failure to timely recognize estimated credit losses could delay appropriate loss-mitigation activity, such as restructuring junior lien loans to more affordable payments or reducing principal on such loans to facilitate refinancings.”
Common Mistake #10. Failure to charge off book value in excess of fair value for collateral-dependent loans. Once the loan is determined to be a collaterally dependent impaired loan, it must be written to the net fair value (appraised value less costs to sell), which in a distressed asset situation generally will be less than the current outstanding book value. In rare circumstances the book balance of the loan may be lower than the current appraised market value, which would require no reserve. However, an excessive number of this type of impaired loan with no reserve specified is a red flag to regulators.
Mistakes Relative to FAS 5 Loans
Common Mistake #1. Segmenting loans by type only, without any incorporation of risk grade. A substandard loan may not automatically meet the definition of an impaired loan. However, if such a loan is significantly past due or in nonaccrual status, it is probable that the bank will be unable to collect all amounts due, and the loan should be measured in accordance with FAS 114. Question #11 from Questions and Answers on Accounting for Loan and Lease Losses states, in part, that banks should separately track and analyze losses on substandard loans.
Common Mistake #2. Poor selection of an historical loss period. Most banks are looking too far back to determine historical losses. Many do not include the current year. The general rule is to look back two years, but the OCC Comptrollers Handbook recommends shorter look-backs or “weighting” during times of economic instability, generally a year.
Common Mistake #3. Adjustments for environmental and qualitative factors are not adequately supported. The bank must calculate the impact of various factors beyond historical look-backs — and document how those factors impact valuations. Internal factors can include bank size, bank loan strategy, management style, portfolio characteristics, loan administration procedures, management information systems, and changes in target markets and associated risk. External factors might include such items as market economic changes or competitiveness within an industry. Examiners are typically suspicious if historical allocations are outweighed by other allocations by 50 percent — or even slightly less that 50 percent.
Common Mistake #4. Lack of back-testing to validate adjustments. What actually happened as compared to what you forecasted? If forecasts have been coming up short, the bank can reduce its look-back period and recalculate or make additional allocations as testing indicates.
Common Mistake #5. Use of unusual adjustments to historical losses without documenting reasons. The bank must be directionally consistent in its analyses. Otherwise it appears as if the bank is creating adjustments in order to reach its desired level of loan-loss reserve.
Other Common Mistakes
Common Mistake #1. No reserve for off-balance sheet items, or failure to include them in ALLL calculations. Off-balance sheet items like overdrafts can impact risk status and will be reviewed by examiners along with more traditional loan obligations. The bank’s reserve must be sufficient to cover risk associated with all binding commitments.
Common Mistake #2. Failure to validate ALLL methodology. Have your auditor or accounting firm periodically validate that you are adhering to your ALLL policy.
Common Mistake #3. Numerous FAS 114 calculations with no reserves. Having too many FAS 114 loans that generate no reserves is a red flag to the field examiner.
Common Mistake #4. Impaired loans remaining on accrual status. This is also a red flag to field examiners. Impaired loans must be on non-accrual status.
The following regulatory publications provide the most pertinent information on requirements related to ALLL:
Note: The content for “Common Mistakes in Determining ALLL” is based on interviews with FDIC examiners. The “common mistakes” represent the objective observations of examiners currently working with community banks.
Dalton Sirmans is CEO of Mainstreet Technologies, Atlanta.
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