Common exam issues related to the ALLL

Nov 3, 2015

The allowance for loan and lease losses (ALLL) is one of the most significant estimates in an institution’s financial statements and regulatory reports, so it’s understandable that the ALLL receives scrutiny from safety and soundness examiners. In fact, the 2015 Sageworks Bank & Credit Union Examination Survey found that about 1 of every 6 institutions was criticized by examiners for the ALLL calculation process, with respondents citing documentation of the calculation and justifications for qualitative factors as two issues drawing criticism.

Walter McNairy, managing partner of DHG Financial Services, a national practice of Dixon Hughes Goodman LLP, believes that financial institutions can avoid ALLL problems with examiners by avoiding several common pitfalls and by addressing certain hot-button issues currently in focus.

Speaking recently at the 2015 Risk Management Summit hosted by Sageworks, McNairy outlined ALLL-related issues that the firm has seen highlighted in various clients’ safety and soundness exams of late.

One common problem that examiners identify is financial institutions lacking documented impairment analyses. McNairy said this issue seems to arise when bankers, observing that real estate values have recovered, become less concerned with conducting an updated impairment analysis or with using documentation that is accurately completed.

“They’ll say, ‘I’ve got this appraisal that’s a year or two old, and my gut just tells me that values have improved.’ If you have an impaired loan, you still have to go in and do a calculation every quarter,” he said. If an appraisal is two years old, bankers should still determine whether and why they can still use it, even if it’s to use as a floor for the value, and they should document this process, he added. [Learn more about documenting the ALLL in this whitepaper, “What Examiners Expect.”]

Lack of support for qualitative factors is another area where examiners often find fault with the ALLL, McNairy said. Financial institutions should aim to document what they looked at in selecting qualitative factors and in making adjustments so that someone could go back and repeat the same review, if necessary. “Even if it’s a one-page update memo that you put in the file every quarter,” McNairy said, institutions will be well served to document supporting evidence for Q factors.

“The more thorough you are in your documentation, and the more clear it is to an examiner or to an auditor that you’ve thought through these things – that you’ve read the various policy statements on Q factors, that you’ve talked to loan officers, you have a disclosure committee or an allowance committee, or a loan review committee — the better off you’re going to be, because now you’ve got some evidence that you’re really thinking about this,” he said.

Examples of support for qualitative factors include economic data or articles describing an economic event that impacts a particular industry or geography relevant to your loan portfolio, he said. Support could also include notes from borrower discussions and notes on the financial institution’s own credit trends. This is especially important for institutions trying to support a higher level of reserves than quantitative factors alone might justify.

“It’s important that whoever is running the model has conversations with the chief credit officer and maybe some loan officers about what really you’re seeing out there,” McNairy said. “They’re probably talking to customers who can say, ‘Yeah, I can make payments, but my business is having some difficulty right now.’ If you can identify segments of your portfolio that are like that, you’re going to be in a much better position to come up with qualitative factors to be able to support” a higher level of reserves, he added.

An additional common exam issue that relates to qualitative factors is when an institution applies a Q factor to all of its unimpaired loans without consideration of the various loan types, McNairy said. For example, one institution adjusted its entire loan portfolio by a 20 basis-point factor it identified related to its concentration of commercial real estate loans. “It doesn’t need to be applied to the entire portfolio; it needs to be applied to the exposure that you’re reserving for,” McNairy said. “That’s just some low-hanging fruit that you’re going to get commented on by regulators if you don’t catch that.”

To learn more about avoiding examiner criticism related to the ALLL, watch a brief video on adding objectivity to qualitative factors or download the whitepaper, “Q Factors: Data, Drivers & Documentation.”