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allowance for loan losses all

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allowance for loan losses all

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    1. 1 Allowance for Loan Losses (ALL) Audit Committee Program Palm Springs, California June 2006

    2. 2

    3. 3 Old School use of allowance Build during good times and use during bad times Report smooth earnings Keep regulators happy - rarely criticized for being over reserved

    4. 4 Focus now on the appropriateness of the allowance Best estimate of “expected losses” imbedded in the loan portfolio. Boards of directors (audit committees) are required to sign off on the “appropriateness” of the reported allowance.

    5. 5 Allowance for Losses Subjective area – not unlike predicting the future. Board and management judgment required. Disciplined methodologies remove ‘old school’ discretion, but still require judgment.

    6. 6 Understanding Risk - Which portfolio is riskier?

    7. 7 Bank “B” is less risky Risk is “volatility” or “uncertainty” It’s the deviation around the mean not the mean itself. Bank “B” is much less risky. It’s average losses are higher but they are much more predictable. Bank “A” has a lower expected losses (2%) but in any year actual losses can be 100% higher or 75% lower. Greater volatility – less predictability.

    8. 8 The role of the Allowance versus Capital The allowance for loan losses is designed to cover “expected” losses The role of capital is to cover “unexpected” losses or the worst case so that the bank remains solvent when things are worse than expected. Think of this: If the level of loan losses was 100% predictable, capital would not be required for loan losses. Banks would simply charge a sufficient spread to cover the certain losses.

    9. 9 Board responsibilities Boards have responsibilities to ensure processes are in place to manage and report on risk Regulatory – FCA and other regulators’ pronouncements Best practice – Basel guidance

    10. 10 Board responsibilities Board oversight responsibilities Regulatory requirements – FCA book letter BL-049 SEC – SAB 102 Basel guidance - Sound Credit Risk Assessment And Valuation For Loans - (Nov. 2005)

    11. 11 Risk management practices Appropriate credit risk assessment process. Effective internal controls process to consistently determine provisions for losses. System to reliably classify loans as to credit risk.

    12. 12 Risk management practices Sound loss methodology Procedures and controls for assessing risk Identify problem loans Determine loss provisions Adequate to absorb estimated losses Experience, judgment and estimates are essential to the process

    13. 13 Risk management practices Risk assessment process should provide Tools, procedures and observable data to assess loan impairments Determine capital needs All of these are subject to periodic regulatory scrutiny.

    14. 14 ALL Background The System adopted a new ALL methodology in the 4th quarter of 2004. This methodology implemented Farm Credit Administration’s (FCA) Bookletter expectations on allowance for loan losses issued in April, 2004. FCA endorsed the Security and Exchange Commission (SEC) and Federal Financial Institution Examination Council (FFIEC) guidance issued in July of 2001.

    15. 15 ALL Determination The ALL account must be determined in accordance with Generally Accepted Accounting Principles (GAAP). Two Statement of Financial Accounting Standards (SFAS) outline the rules for the determination of the ALL amount. SFAS 114, as amended. Individual loan impairment. SFAS 5. Collective loan impairment. Individual loan impairment plus collective loan impairment equals the ALL amount.

    16. 16 Individual Loan Impairment Individual loan impairment guidance has remained unchanged for several years. An accrual of a loss should be recorded if it is probable that a loan has been impaired and the loss can be reasonably estimated. A loan is considered impaired if it is probable the loan principal and interest will not be collected in full or substantially as scheduled in the loan contract.

    17. 17 Individual Loan Impairment (cont’d) High risk loans (i.e., nonaccrual, 90 days past due, formally restructured) are considered impaired loans. The measurement of impairment may be based on: Present value of the future cash flows. Fair value of collateral if collateral dependent. Observable market price.

    18. 18 Example of Individual Loan Impairment Given: Real estate mortgage loan with a legal obligation of $120,000. Impairment determination measured on the fair value of the collateral basis.

    19. 19 Example of Individual Loan Impairment (cont’d) Note: All high risk loans would be analyzed for individual loan impairment.

    20. 20 Collective Loan Impairment The System changed methodology in this area in 2004. Loans that are evaluated on a group basis, i.e., groups of loans where it is probable that loans are impaired even though losses cannot be identified on any individual loan. Institutions must follow a systematic and consistently applied approach for calculating collective loan impairment.

    21. 21 Collective Loan Impairment (cont’d) The level of collective loan impairment should be based on historical loss rates adjusted for current conditions. One approach for determining collective loan impairment is utilization of the System’s 14 point risk rating model.

    22. 22 Example of Collective Loan Portfolio Analysis Utilizing System’s 14-Point Risk Rating Model Expected losses (EL) equals probability of default (PD) times loss given default (LGD) times exposure at default (EAD) (i.e., EL= PD X LGD X EAD). Each loan in the portfolio is periodically risk rated. Benchmarks are established for PD, LGD and EAD. Over time, institutions should replace benchmark data with their own data.

    23. 23 Example of Benchmark Data for PD Utilizing Standards & Poor’s Database

    24. 24 Example of Benchmark Data for PD Utilizing Standards & Poor’s Database (cont’d) Note, as risk ratings increase, PDs exponentially increase. Volatility is caused by volume in higher risk categories (i.e., 9, 10, 11, 12, 13, 14).

    25. 25 Benchmark Targets for LGD

    26. 26 Benchmark Target for EAD The benchmark target for EAD is 100% of commitment.

    27. 27 Individual Loan Example for Collective Loan Impairment Given a $35 million dollar commitment on a risk rated 7 loan that is adequately secured:

    28. 28 Changes in ALL Methodology Occurring with the Changes in the Collective Loan Amount Process

    29. 29 Volatility Example

    30. 30 Volatility Example Expected loss (allowance amount) would increase to $1.2 million if LGD dropped from 8% to 25% (acceptable to marginally secured) at the same time the risk rating dropped from 7 to 10.

    31. 31 Other ALL Considerations Increases or decreases in risk of loss should be reflected in the balance sheet and flow through the income statement on a directionally consistent basis. ALL process should be validated. Adjustments to the process should be made to reduce differences between estimated losses and actual subsequent charge-offs.

    32. 32 Example of ALL Process

    33. 33 Example of ALL Process (cont’d) Assure proper risk ratings and accounting classification on total loans. Identify loans to be evaluated for individual loan impairment. These are high risk loans. The amount used in this example is $5,150,000.

    34. 34 Example of ALL Process (cont’d) Calculate individual loan impairment amount. Individual loan impairment is calculated on each high risk loan utilizing the fair value of the collateral method for collateral dependent loans (i.e., net realizable value of the collateral less legal obligation of the borrower). The individual loan impairment amount used in this example is $515,000.

    35. 35 Example of ALL Process (cont’d) Identify loans to be evaluated for collective loan impairment. This is total loans less impaired loans. Establish the collective loan impairment pool. In this example $1,664,000,000 is used (i.e., EAD). This is the total commitment on loans identified to be evaluated for collective loan impairment.

    36. 36 Example of ALL Process (cont’d) Calculate the collective loan impairment amount. This would be completed on each loan and then totaled utilizing the following formula: EL = PD x LGD x EAD. In this example, weighted average pool totals are illustrated.

    37. 37 Summary of ALL Process Add individual loan impairment amount to collective loan impairment amount to get ALL amount. $515,000 plus $4,046,515 equals $4,561,515 ALL amount. The previous quarter’s ALL amount was $4,000,000. A $561,515 provision is needed to bring the ALL amount to $4,561,515. This decreases earnings by $561,515 for the quarter.

    38. 38 Validation Required in FCA guidance and SAB 102 Accurate estimation of losses over period of years is the requirement Validation should review: Charge-off and recovery history Trends in volume, delinquencies, restructurings, concentrations, etc. Model assumptions Accuracy of collateral valuation process

    39. 39 Audit Committee Considerations Ensure board understanding of adequacy of allowance Relate to overall business strategies Ensure management polices address institution’s goals, systems, risks, personnel, etc. Identify exposure to losses Ensure adequate level of allowance

    40. 40 Audit Committee Considerations Oversee the allowance process Consistent with institution’s policies Consistent with GAAP Recognition of impaired and nonaccrual loans Recording of charge-offs

    41. 41 Audit Committee Considerations Documentation of the process Review management’s analysis, determination of adequacy and changes to the process. Coordination and communication with outside auditor. Review and approve the ALL

    42. 42 Questions for Audit Committees Continual adjustments to allowance methodologies Lack of supporting data on specific reserves If character of portfolio is changing, are allowance methodologies still valid?

    43. 43 Roles and Responsibilities Full board is charged with ensuring that the Allowance for Loan Losses is adequate. Full board usually looks to Audit Committee to review the adequacy of the reserve. Audit Committee is charged with reviewing key accounting judgments. In a bank there are generally 3 or 4: Provision for loan losses and the adequacy of the allowance. Pension costs and liabilities. Year end accruals and reserves. Derivative transactions.

    44. 44 Roles and Responsibilities To fulfill that oversight role: Become familiar with the processes around developing the estimates Use the resources you’ve hired to help you understand them Internal audit External auditor

    45. 45 Q&A

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