How CEIS Review Can Help with Your ALLL Validation Process
CEIS regularly is engaged with Banks and Credit Unions to validate their existing loan loss reserve methodology. The process involves CEIS reviewing the existing loan loss reserve methodology for conformance to regulatory guidelines, reasonableness in establishing the reserve allocations, conformance with GAAP standards, and that the methodology is well documented in the Clients policies.
We will analyze, test and validate the methodology underlying the specific and general allocations that are applied in the client’s periodic assessment of loan loss reserves.
CEIS analyzes the portfolio experience of the last three-to-ten years, including the migration of loan grades, loss experience, reliability of the loan grading system and changes in the portfolio mix. We also scrutinize trends in portfolio risk in view of concentrations such as large loan exposures, loan types, collateral types, industry and loan grades; delinquency and non-accrual trends, off balance sheet commitments, the loss experience of its “peers,” and other factors relevant to the client portfolio profile.
In today’s regulatory environment, Banks are typically expected to have their LLR methodology reviewed at least once every 12 months. Contact us today to learn more.
A Brief Review of Allowance for Loan and Lease Losses (ALLL)
Originally known as “the reserve for bad debts,” Allowance for Loan and Lease Losses (ALLL) is the reserve established by financial institutions to reflect the estimated credit losses within their portfolio of loans and leases. These estimates of uncollected amounts, or “impaired loans,” represent the net charge-offs that are likely to be realized against an institution’s operating income as of the evaluation date (generally, the quarterly balance sheet date).
According to the Federal Reserve, the ALLL should be included on the balance sheet as a “contra-asset account.” This serves to reduce the total book value of a bank’s loans and leases to the amount that it expects to collect.
ALLL estimates and the methodologies used for calculating them are subject to regulatory scrutiny by multiple federal agencies: the Federal Reserve Board (FRB); the Federal Deposit Insurance Corporation (FDIC); the Office of the Comptroller of the Currency (OCC); the National Credit Union Administration (NCUA); and the Office of Thrift Supervision (OTS). The regulatory requirement for ALLL reserves applies not only to banks, but to credit unions and financial savings associations as well.
How is ALLL Calculated?
In their hallmark 2006 Interagency Policy Statement on ALLL, the agencies state that it “represents one of the most significant estimates in an institution’s financial statements and regulatory reports.” Institutions are directed to document their ALLL at the end of each quarter, “or more frequently if warranted.”
Because of its significance, an institution’s methodology for deriving its ALLL estimate is a critical area of focus in its safety and soundness exam.
The Interagency ALLL regulatory directive addresses the process and methodology for calculating loan and lease credit losses, stating “each institution has a responsibility for developing, maintaining, and documenting a comprehensive, systematic, and consistently applied process for determining the amounts of the ALLL and the provision for loan and lease losses (PLLL).”
The agencies’ statement further directs financial institutions to determine their ALLL in accordance with the methodology of the Generally Accepted Accounting Principles (GAAP), which are based on the latest accounting standards for financial reporting issued by the Federal Accounting Standards Board (FASB). Current GAAP requires institutions to use an “incurred loss” methodology for recognizing credit losses that delays recognition until it is probable a loss has been incurred.
What are Some of the Common Challenges Financial Institutions Face with ALLL?
In June 2016, the FASB issued a new accounting standard, Accounting Standards Update (ASU) 2016-13, which introduced the current expected credit losses (CECL) methodology for estimating ALLL. CECL will replace the incurred loss methodology once it goes into effect from December 2018 (for early applicants) to December 2020.
In its credit losses project update, the FASB explained its decision to replace the incurred loss methodology with CECL were for several reasons, foremost among them being the lack of “forward-looking information” in the incurred loss model. The incurred loss methodology’s delayed recognition of credit losses potentially results in the overstatement of assets, which the Financial Crisis Advisory Group (FCAG) identified as a weakness in the model
The change in methodology is also intended to “significantly improve the decision usefulness” for the users of financial statements, such as bank managers and directors, who have expressed frustration with the incurred loss methodology because they could not record credit losses that they were expecting due to the fact that the “probable threshold” had not been met.
Other objectives of the GAAP project are to simplify the ALLL accounting requirements for financial institutions, and to develop a single, uniform credit loss model for financial assets that “enables more timely recognition reporting of credit losses.”
The promise of the streamlined, forward-looking CECL methodology for resolving the common challenges now faced by financial institutions in estimating ALLL remains to be seen.