In December 2006, the federal banking agencies issued guidance on reserve adequacy. The guidance stated that a bank’s directorate and management are responsible for making sure the ALLL is appropriately funded each quarter. Additionally, the board and management must ensure that uncollectible loans are charged off promptly.

In their guidance, the federal banking agencies noted that loan portfolio review is the cornerstone for any analysis of ALLL adequacy and that the board and bank management must have in place loan review and loan grading systems that permit accurate and timely identification of problem loans.  Further, the internal rating system used by a bank to generate a “watch list” of problem loans should be reconcilable to the loan grading system used by bank examiners in order to enable comparisons of internal and examiner loan ratings. 

The agencies stress that a bank should not make historical experience the sole predictor of credit losses in the bank’s current loan portfolio.  An appropriate ALLL must also consider factors that may cause future losses to deviate from past loan losses.  Factors to consider include changes in:

• Lending policies and procedures.
• Underwriting standards.
• The nature and volume of the asset portfolio.
• The experience and ability of the lending staff.
• The overall quality of the bank’s portfolio.
• The quality of the bank’s loan review system.
• The degree of oversight by the bank’s board.
• The amount of credit concentrations and economic and business conditions the bank faces.

The Report of Condition and Income includes data on the bank’s ALLL balance. At a minimum, the process of estimating an appropriate ALLL balance and reporting results to the board must be done quarterly so that the bank meets Report of Condition and Income filing requirements to its primary federal banking supervisor. 

In this quarterly review of the ALLL, the agencies suggest using ratio analysis as a starting point in the evaluation of ALLL adequacy.  Basic ratios such as the coverage ratio are discussed in the Basic Ratio Analysis lesson in your meeting materials, while several more specific ratios are covered in the Asset Quality Assessments lesson.

A review of ALLL adequacy, including ratio analysis, should compare the current ALLL balance against history, budget and peer values. For more information about making these types of comparisons, see the lesson on Making Financial Comparisons in your meeting materials.