The two D’s of the ALLL: Data and documentation
One critical component of the ALLL is data-gathering and documentation. The reserve is more than simply a calculation of funds, and a lack of or insufficient data and/or documentation is often a sore spot for many banks and credit unions. Whether an institution assesses the ALLL monthly or quarterly, collecting portfolio-level and loan-level data is often the most time-consuming aspect of the process, but a crucial one.
As a result of ASU 2010-20, all banks that have audited financial statements must provide disclosure reports to their examiners. The main objective of disclosure reporting is increased transparency to financial statement users about institutions’ allowance for credit losses and the credit quality of their financing receivables.
Choosing the right peer group
Peer analysis is a tool many banks use to provide benchmarks and context for financial results. Selecting that peer group is critical for the peer analysis to be accurate. Too often, banks use peers with whom they compete directly for revenue and do not give regard for the non-revenue parts of the profiles with which they are more closely aligned.
Included in the 2006 Interagency Guidance was a statement that “Policies should require periodic validation of the methodology.” It is typically recommended that these model validations take place annually to ensure the methodology complies with Interagency Guidance/GAAP, and that it is appropriate for the portfolio.
Defending Qualitative Factors
When it comes to defending Q factors, documentation is key. An institution will be well suited to defend their qualitative and environmental risk factors if they are objective, directionally consistent, and properly document their assumptions.
Standard Qualitative Factors
The 2006 Interagency Policy Statement on the ALLL included recommendations for nine qualitative factors. These consist of six internal factors, which focus on changes within the institution (ex. “Quality of the organization’s loan review system”), and three external qualitative factors, which pertain to the outside environment and are independent of the institution’s performance (ex. “International, national regional and local conditions”).
Reporting: Benefit Beyond Compliance
Above and beyond regulatory expectations for disclosure reporting, Rhoda Lauver of Jonestown Bank and Trust Company in Lebanon, Pennsylvania, believes that reporting on ALLL results should be pervasive throughout many areas of the bank.
How FANB readies its ALLL data
A past due loan report is used to review loans needing a downgrade due to days past due or days past due in combination with history. Commercial loans over 90 days past due are placed on non-accrual. Consumer loans, including home loans, are typically assigned non-accrual at 90 days but in some cases where a workout is in process or collateral value exceeded the fair market value less cost to sell & the loan is in collection, non-accrual is not assigned until 120 days past due.
ASC 310-10-35 (FAS 114)
Institutions should begin to gather the necessary documentation, both internal and external, before commencement of the ALLL calculation. Many sources of information, such as appraisal values or cash flow schedules, may require updating prior to the time of the calculation. As such, institutions should be mindful of documentation requirements as they begin to plan for their ALLL calculation.
Vendor Due Diligence
Regulatory bodies expect financial institutions to practice effective risk management regardless of whether they perform the activity internally or through a third party. According to the Bulletin of the OCC, an effective, third-party risk management process follows a continuous life cycle for all contractual relationships and incorporates the following phases
Justifying a Change
Though a consistently applied ALLL does not typically result in a drastic change, certain improvements may merit inconsistencies. If an institution moves to a more sophisticated model (e.g. migration analysis over historical loss rates), some inconsistency from the prior period may arise, but should be acceptable in the eyes of examiners if the methodology is transparent and well-documented.
Backtesting for Reporting
Backtesting is an exercise that compares the actual outcome with model forecasts during a defined period. It can be considered a form of outcome analysis to monitor model performance and determine if adjustments or revisions are needed over time.
Presenting to Auditors
Similar to presenting ALLL results to examiners, documentation is of the utmost importance in defending your ALLL methodology to auditors. Because the role of an auditor includes protecting shareholders, you must be able to transparently explain your methodology at the time of an audit and provide the proper documentation to ensure that your ALLL calculation is both objective and in line with guidance.
Presenting to Examiners
When presenting the ALLL results to examiners, it is imperative that financial professionals include the proper documentation. Any and all assumptions must be documented, and the examiner should be able to view the input of the methodology and how the financial institution arrived at its final number.
Presenting to Board
When presenting ALLL results to the board, financial professionals do not need as much documentation as is necessary for examiners. Rather, they should keep the presentation concise, objective and focus on the big picture.
Objectivity in Adjustments
There are various measures institutions can take to add objectivity to the otherwise subjective task of qualitative and environmental risk factors. These consist of incorporating a qualitative scoring matrix into your Q factor analysis, ensuring directional consistency, and sticking to the nine recommended Q factor adjustments, among other things.
Backtesting refers to retroactively validating the accuracy of an institution’s methodology. This consists of pinning the ALLL calculation against actual credit losses to determine the degree of variance. Having a consistently accurate ALLL can serve as an invaluable tool in validating your methodology and defending it to regulators.
Before an institution can begin on the ALLL calculation, it must first gather and prepare the necessary data. This may require collecting data from disparate sources and converting the data from an illegible core output to a ready-to-use format. If an institution uses an automated solution that integrates with its core, this step in the process may not be necessary.
The ALLL calculation should be objective in nature; that is, when attributing qualitative and environmental factors to the allowance, there should be sound reasoning as to why certain adjustments were made. An objective ALLL ensures that there is no management bias or partiality to skew the results of the calculation one way or another.
Institutions must perform the ALLL calculation in such a manner that the assumptions from one period to the next are justified and consistent. From calculation to calculation, assumptions should reflect any changes in the loan portfolio, management adjustments be directionally consistent with the environmental landscape and the methodology should be largely repeatable.
It is imperative that outside parties understand an institution’s ALLL methodology. Those that examine the methodology must be able to see the various components of the calculation and all assumptions that go into it.