The following provides a brief
summary of a process for determining amounts for each ALLL component. The
material that follows is somewhat complex, so pay close attention to the examples. Follow up with the practice items and you’ll have a good understanding of the ALLL calculation process
and be better able to ask questions when you review the adequacy of the
loan loss reserve for your bank. The Try This at Your Bank exercise: Determining an Appropriate Reserve provides some additional questions for you to consider.
FAS 114 Component – Accounting By Creditors for Impairment of a
Loan
FAS 5 Component – Accounting for Contingencies
Determining the Addition to the ALLL
FAS 114 Component – Accounting By Creditors for Impairment of a Loan
 Steps for determining FAS 114 component of the ALLL
| 1. |
Establish criteria for loans that
will be reviewed individually. The criteria that are used
is up to the bank (for instance, loans over a certain size, watch
list loans, etc). |
Bank A has $10,000,000 in loans.
It has identified $3.5 million in loans that it will review individually
for impairment. These are the bank’s FAS 114 loans. |
| 2. |
Review these loans to identify any impairment.
IMPAIRED LOANS are loans for which the bank does not expect
to receive contractual interest and/or contractual principal
by the contractual due date.
|
After its quarterly review, Bank
A determines $3 million of its FAS 114 loans are impaired. |
| 3. |
Categorize all impaired loans as “COLLATERAL DEPENDENT,” “SALEABLE,” or “CASH
FLOW”
COLLATERAL DEPENDENT LOANS are loans that will be repaid
from the liquidation of or rents from the collateral. For
most small banks, this will probably be the biggest category
for the FAS 114 loan category and because of this the discussion
is limited to treatment of collateral dependent loans.
Collateral dependent loans are valued at the appraised value
of the collateral, adjusted for:
a. the holding period before the collateral will be
sold;
b. the costs of maintaining the collateral during
the holding period;
c. the probable discount because the bank is the seller;
d. rhe costs of selling the collateral; and
e. any other economic or financial factors affecting
the realizable value of the collateral. |
Collateral dependent loans $2,500,000
Saleable loans $160,000
Cash flow loans $40,000
|
| 4. |
The estimated values for loans in
the three categories is summed to generate subtotals, omitting
the loans whose fair value equals or exceeds their book value.
The subtotals are then summed to generate the fair value or grand
total for individually reviewed impaired loans. This fair
value is subtracted from the grand total of outstanding balances
on these loans to derive the amount for the FAS 114 component
of the ALLL. |
Estimated value of individually reviewed
impaired loans $3,000,000
Collateral dependent $2,500,000
Saleable loans $160,000
Cash flow loans $40,000
Total $2,700,000
Total FAS 114 estimated losses $300,000
The value of the impaired loans is estimated to be $2.7
million, resulting in an estimated $300,000 loss. |
| 5. |
The $500,000 in FAS 114 loans that
were reviewed but were determined to be unimpaired are grouped
together and used in Bank A’s FAS 5 analysis. |
|
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FAS 5 Component – Accounting for Contingencies
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 an event that is rumored to happen sometime in the future) and that
can be estimated. For example, if a manufacturing plant closed and 20 or
30 of the newly unemployed workers are your bank’s loan customers,
the bank may suffer some loss and an additional provision to increase
the ALLL may be justified. If the plant closing is only rumored,
such a provision would not be necessary.
Steps for determining FAS 5 component of the ALLL
As you learned in the previous example, Bank A has $10 million in loans,
$3 million of which it reviewed individually for impairment. The
remaining $7 million in loans will be broken into segments or categories
based on homogenous risk characteristics. Also included in Bank A’s
analysis is the group of unimpaired loans from its FAS 114 analysis.
| 1. |
The FAS 5 component is determined by dividing the remaining
portfolio (the loans that weren’t used in the FAS 114
calculation) into segments of loans with similar risk characteristics.
|
In this case, Bank A uses the broad
loan categories found on its Call Report: ag loans, business
loans, consumer loans and real estate loans.
The $500,000 in FAS 114 loans that are not impaired are
grouped together and are used in Bank A’s FAS 5 analysis. |
| 2. |
A loss factor (or rate) is then applied to each group to
obtain an estimated loss.
It is important to note that the loss rate on the FAS 114
group may be higher than that on other loan loss groups.
Typically, these loans have already been singled out for
individual review because management may believe that they
represent a higher credit risk.
|
From past experience, the bank knows
that, on average, it will have to charge off 1 percent of agriculture loans, 2 percent of business loans
1.5 percent of consumer loans and .5 percent of real estate loans.
Also included in Bank A’s analysis is the group of
unimpaired loans from its FAS 114 analysis. Historically,
the loss rate on these loans has been 4 percent and management
expects this rate to continue into the future. |
| 3. |
The loss factors are usually based on historical loss experience
and then adjusted for anything that may cause losses to deviate
from past experience, such as a change in lending staff or
in loan policies.
If historical experience doesn’t exist, a competitor’s
experience or management’s best estimate can be used.
However, care should be exercised in using competitors’ experience,
because of the effects that differences in underwriting standards
can have on loss.
|
Bank A’s management believes
nothing has occurred at the bank to cause historical loss rates
not to remain valid over the next year. |
| 4. |
After the loss is determined for each loan segment, the losses
are summed.
(The amount of loss is first divided by 4 to generate a
quarterly loss rate.)
This sum is the FAS 5 component of the reserve.
|
Agricultural loans
$2,000,000
x .010 = $20,000/4 = $5,000
Business loans
$1,000,000
x .020 = $20,000/4 = $5,000
Consumer loans
$1,000,000
x .015 = $15,000/4 = $3,750
Real Estate loans
$3,000,000
x .005 = $15,000/4 = $3,750
FAS 114 loans
$500,000
x .040 = $20,000/4 = $5,000
Total FAS 5 estimated losses = $22,500
|
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Determining the Addition to the ALLL
Steps for determining the Addition to the ALLL
| 1. |
The FAS 114 and FAS 5 components are summed to generate a total estimate of loan loss. This total represents management’s best estimate of the expected loss in the portfolio. |
In the case of Bank A, the estimated
ALLL is $322,500.
Estimated ALLL = FAS 114 + FAS 5
$300,00 + $22,500 = $322,500
|
| 2. |
The expected loss is compared with the current ALLL balance
and provides a basis for deciding how much to add or subtract
from the ALLL.
|
Bank A’s current ALLL balance
is $298,000.
Estimated ALLL - Current ALLL balance = Provision needed
$322,500 - $298,000 = $24,500
|
As mentioned before, the agencies stress that banks must maintain documentation
to support their ALLL balance. Among other things, written policies
and procedures should set out or establish:
- The roles and responsibilities for those that develop the reported
ALLL balance.
- Policies for charge-offs and recoveries, and for estimating the
fair value of collateral.
- The bank’s methodology for determining its ALLL.
- Internal controls to ensure the ALLL is estimated according to
accounting and supervisory guidance.
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