Publications & Resources
January/February 2008
Focus: Compliance
How Can Privately Held Banks Properly Calculate and Support an ALLL that Meets Both GAAP and Regulatory Requirements?
By
New Rules in Effect for 2007
On Dec. 13, 2006, the joint regulatory agencies issued an interagency policy statement (IPA) on the allowance for loan and lease losses (ALLL). Its issuance appears to have settled a three-decades-old debate between accountants and regulators as to the true definition, purpose and method of calculating the ALLL.
At long last, the regulatory agencies stated that the purpose of the ALLL is not to serve as a “Multi-Risk Capital Cushion,” and that it is not designed to absorb all of the risks in a bank’s loan portfolio. Banks that have high levels of risk in the loan portfolio or are uncertain about the effect of possible future events on the collectability of the loans should address these concerns by maintaining higher equity capital and not by arbitrarily increasing the ALLL in excess of amounts supported under GAAP.
The new IPA requires bankers not only to support the magnitude of the ALLL with hard (FASB 5 & FASB 114) rule-oriented data, but also separately develop and document information that proves that their capital structure can withstand any potential generic portfolio risks, such as industry concentration (i.e. commercial real estate loans).
Calculating the ALLL – GAAP Rules Prevail
Generally Accepted Accounting Principles (GAAP), particularly as set forth in FASB 5 & FASB 114, are the cornerstones of a bank’s ALLL calculation.
An appropriate ALLL covers: (a) under FASB 114 – estimated credit losses on individually evaluated loans that are determined to be impaired; and (b) under FASB 5 – estimated credit losses inherent in the remainder of the loan portfolio
Banks must strictly apply these rules to the risk of loans becoming, or having already become, less than 100% collectible, e.g. impaired (including any interest or fees set forth in the original loan underwriting). Impaired means that based on current information and events, it is probable that a bank will be unable to collect all amounts due. Probable means likely to happen. Further, the magnitude of the probable loss must be reasonably estimated.
FASB 5 also states (paragraph 22) that once a loss has been determined probable and subject to estimate, the loss can be applied to individual loans or in relation to groups of similar types of loans, even though the particular loans that are uncollectible may not be identifiable.
So, with this in mind, banks need to document both their FASB 114 and FASB 5 criteria and methodology. Here are some suggestions.
First identify the list of specific loans in the loan portfolio that might be potentially impaired using the FASB 114 criteria. Ascertain which of the three impairment measurement methods is most applicable. The three are: (1) the present value of expected future cash flows discounted at the loan’s effective interest rate; or (2) if saleable, the loans’ observable market price; or (3) if the loan is collateral dependent, the fair value of the collateral.
Then establish specific quantifiable valuation amounts for “each” impaired loan. The amount of the valuation must be supported by adequate documentation. The sort of documentation would depend on which of the three impairment measurement methods is used. For example, for collateral-dependent loans for which the bank must use the fair value of collateral method, the bank should document: (1) how fair value was determined including the use of appraisals, valuation assumptions, and calculations; (2) the supporting rationale for adjustments to appraised values, if any; (3) the determination of costs to sell, if applicable; and (4) appraisal quality and the expertise and independence of the appraiser.
Once this is done, the next task is to assess the magnitude of the required valuation reserve on the remainder of the loan portfolio using comprehensive risk analysis.
First, identify risk characteristics that are common to various groups of loans. One broad group could be installment loans. These could be further refined into new or used car loans, home equity loans of credit, or perhaps student loans. The key is to first determine the common risk elements and then create the groups.
For further information and some helpful examples, see FIL Letter-63-2001 on the FDIC website.
Conclusion
The IPA clarifies what the ALLL should cover and how to calculate it – GAAP reigns supreme. The IPA also states that capital adequacy might have to be higher for those banks that have more risk in their loan portfolios. By separating the two issues, it should serve to moderate the conflict between the GAAP and RAP rules.
Richard
Sprayregen is director of the Financial Institutions Group for Moss Adams LLP in
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