Although it is unlikely that you would ever be responsible for actually developing your bank’s estimated ALLL balance, it may help to know the process for determining an apppropriate reserve amount when it comes to establishing or changing the bank’s ALLL policy.

In estimating an appropriate ALLL, it is easiest to think of the reserve as consisting of two components. These components are typically referred to by the accounting statements that provide guidance on their calculation. These statements are issued by the Financial Accounting Standards Board and include financial Accounting Standard No. 114, Accounting by Creditors for Impairment of a Loan, or FAS 114, and Financial Accounting Standard No. 5, Accounting for Contingencies, or FAS 5.

The FAS 114 component consists of the estimated loss on impaired loans that are reviewed individually.  Impaired loans are loans for which the bank does not expect to receive contractual interest and/or contractual principal by the contractual due date.  The choice of which loans to review is left to the discretion of the bank but it often might include large loans and loans identified as problems through the loan review process and by bank examiners.  It might include past due and nonaccrual loans as well.

The FAS 5 component is the estimated loss in homogenous groupings of loans with similar risk characteristics. In practice, these are grouped by type of loan.  The FAS 5 component of the ALLL consists of all losses that are probable (that result from an event that can be identified and that has already happened, not rumored to happen sometime in the future) and that can be estimated.  The segments should consist of loans with similar risk characteristics.  For example, all auto loans may be grouped to form one segment.  Home improvement loans may be grouped together to form another segment.  Even the loans considered individually as part of the FAS 114 component that are not impaired (and, as a result, for which no provision was made) may be grouped together to form a segment. 

The sum of the two components constitute management’s best estimate of an appropriate reserve balance.  Because estimates of loss involve considerable judgment, an appropriate ALLL balance can be stated as a range of values instead of a single amount.

When an estimated appropriate reserve amount is determined, it is compared with the current balance in the ALLL. Where the estimated balance is above the actual balance, the bank allocates part of its revenue to the ALLL to make up the difference. Without frequent assessments of the ALLL balance’s adequacy, information in ALLL reports may be inaccurate, which could subject the bank to civil money penalties and supervisory action. 

An analysis that is done in accordance with FAS 114, FAS 5 and banking agency policy guidance should provide a reasonable estimate of appropriate reserve.  In the past, some banks held an extra amount in the reserve, sometimes labeled as “excess reserves,” to account for imprecision in estimating an appropriate ALLL balance.  With today’s methods, however, there should be no ALLL component designated as excess reserves or an amount added for uncertainty.