One challenge bankers face in periods of low loss is the ability to objectively maintain reserve levels. If they release reserves without caution, then any future economic downturn could prove costly. In this brief video, a Abrigo consultant shares a few items to keep in mind during periods of low loss.
A Abrigo consultant describes how institutions can use the results of the ALLL in areas such as stress testing and insight into portfolio performance. A lot of the data utilized for the ALLL goes into a top-down, institution-level stress test, and much of the information extracted from the analysis of the ASC 450-20 (FAS 5) portion of the ALLL can be leveraged to determine which products are performing, which are most risky and in which direction the institution wishes to go with its portfolio.
Effective loan classification is a must for an effectively calculated ALLL. In this video, a Abrigo consultant describes the parameters guidance sets out to identify an ASC 310-10-35 (FAS 114) loan. Typically these loans are evaluated individually and a fair market value of collateral or a present value of future cash flow analysis will be conducted to determine the loan's value.
This brief video touches on the topic of segmentation within the ASC 450-20 (FAS 5) portion of the ALLL calculation. While generally the more granular an institution gets, the more defensible the calculation is in the eyes of examiners, there certainly is a tipping point. Institutions must maintain statistical relevancy and ensure that they do not over-segment their pools. Finding a good balance can help institutions to gain more insight into their portfolio, have a more concise calculation and be better equipped to defend their methodology to auditors and examiners.
Whenever there is a sharp change in the ALLL, documentation showing why it is merited will be pivotal. An institution's ALLL should always be objective and well-documented, but this is even more important when there is a drastic change to your ending ALLL balance. In particular, examiners may give greater scrutiny to your qualitative and environmental factors and your ASC 310-10-35 (FAS 114) cash flow impairment analysis. Ensure that you have supporting documentation demonstrating that you have been directionally consistent with your Q factors and that your cash flow impairment analysis is void of any "excessive optimism."
The monthly payment from a loan's amortization schedule is not the same as a loan's expected monthly payment when performing the ASC 310-10-35 (FAS 114) impairment analysis. Thus, to expect the full amortization schedule is highly unlikely, so you must be able to arrive at a number that is defensible with regards to expected monthly payments. The speaker recommends looking backwards at the last twelve months and averaging the payments in order to arrive at a monthly amount that is defensible to examiners.
As institutions grow in sophistication and evolve generally, their calculations should grow with them. While de novo institutions may be forced to use peer data to gather some form of loss experience, it is expected that they graduate to the historical loss methodology once they have sufficient loss experience. Likewise for longstanding institutions, as their data gathering processes become more advanced, they should switch to a more comprehensive analysis in order to have an ALLL that paints a better picture of the true credit risk to which they are exposed.
This video discusses why qualitative and environmental risk factors represent one of the most difficult portions of the ALLL calculation. However, these do not have to be a "black box." There are ways to add objectivity and to objectively defend your assumptions. The speakers discuss best practices in calculating these adjustments as well as defending them to examiners.
Abrigo consultants discuss where examiners will look after a significant change to an institution's ALLL. "If there's a blindfold on the examiner and he/she walks into your institution, they are going to point to the qualitative factor section of the ALLL first," says Ed Bayer. He also mentions cash flow impairment analysis assumptions and recommends institutions be prepared to defend against any comments from examiners that they are showing "excessive optimism" in how much they expect to get back.
This video covers the differences between the two underlying accounting guidances factoring into the ALLL calculation. While there are some gray areas, typically the existence of an impairment, or the knowledge that the loan will not be paid back in full, including both principle and interest, is the determining factor as to whether a loan will be deemed as an ASC 310-10-35 versus an ASC 450-20. The video goes into more detail.
There are three key factors that examiners look for when examining an institution's allowance for loan and lease loss calculation. The first of the three involves loan classification and making sure the institution has a defined set of criteria for determining which loans are to be classified as ASC 450-20 (FAS 5) and which to be classified as ASC 310-10-35 (FAS 114). The Abrigo consultant walks through specific examples of criteria to be used to determine this, and then continues to speak on the other two main factors that examiners look for when evaluating an institution's ALLL.
Todd Sprang, Principal of CliftonLarsonAllen, mentions that many institutions mistakenly use an unallocated reserve to make adjustments that may well be within the scope of the nine recommended qualitative factors. Sprang recommends that institutions use an unallocated reserve that is no more than 10% of their total reserve, and to use qualitative and environmental factors where necessary to ensure their unallocated reserve is not artificially high.