Loan loss provisioning methodology has become a focus for regulators of community banks. During a recent RMA audioconference, the issues of how to calculate loan loss reserves and what the examiners' expectations are were discussed by a panel consisting of Barbara Grunkemeyer, deputy comptroller for credit risk at the Office of the Comptroller of the Currency; Mikkalya Murray, executive vice president and chief credit officer of Harleysville National Bank; and Glenn L. Wilson, executive vice president and senior lender and credit officer of Citizens National Bank. This article is an edited transcript of the audioconference.
Barbara Grunkemeyer Two-thirds of our recent supervisory recommendations deal with the methodology of the allowance as opposed to the adequacy. Sometimes, of course, recommendations deal with both. So I will start off with what our expectations are for the ALL methodology.
'Four documents guide what the 0CC and other regulators' expectations are for the allowance: the inter-agency guidance issued in July 2001, our Comptroller's Handbook on the subject of the allowance, and accounting documents FAS 5 and FAS 114.
Recent pronouncements by the accounting industry have made it clear that there should be two components of the allowance: a component for FAS 114 and a component for FAS 5. FAS 5 sets the standards for when to establish a loss reserve--when it's probable that an asset is impaired and when the amount of loss can be reasonably estimated. In other words, when it's probable or likely that a loss will be incurred, an allowance or reserve should be established.
Impairment is the same for both FAS 5 and FAS 114. A loan is impaired when it is probable that a creditor will be unable to collect all amounts due, principal and interest, in accordance with the terms of the loan agreement. So we have payment in full of interest, payment in full of principle, and the timing of the payments. This definition, as I'm sure you are aware, is very similar to the standards for nonacerual. So in essence, any nonaccrual loan is considered impaired from an accounting standpoint.
The ground rules consist of two components. A reserve should be established when it appears probable that a loss will be incurred and that the loss is estimable, and reserves should be established for loans that are impaired.
ALLL Methodology. We are looking for three things in ALLL methodology:
1. Policies and procedures that describe how a bank segments its portfolio.
2. Policies and procedures for determining how to measure the impairment of those loans that are individually evaluated, as per FAS 114.
3. A methodology for how to determine and measure the impairment in groups of loans or portfolios of loans with similar characteristics as required under FAS 5.
With FAS 114, a bank needs to determine how it identifies those loans that will be individually evaluated for impairment. Although impairment is nonaccrual, a bank should look beyond the portfolio of loans that are nonaccrual for other loans that may become impaired in the near term. Once they've identified the group of loans to analyze for individual impairment, they need to determine how they're going to analyze the loans. FAS 114 lays out three methods.
1. Fair value of collateral. Most community banks, which tend to be collateral lenders, will be looking toward the fair value of collateral. And in doing that, they need to understand how the fair value was determined, what the expected costs to sell are, and if there are any needed adjustments to the appraised values to determine the fair value of the collateral.
2. Present value of expected cash flows. Banks that are using the present value of expected cash flows need to determine the amount and timing of cash flows as well as the effective discount rate.
3. Observable market price. It's less likely that smaller banks will have loans for which there is an observable market. That's not to say that they won't be selling loans, but it may be difficult to obtain a market price.
With FAS 5, the bank's first challenge is to segment the loan portfolio into pools of loans with similar characteristics. Then they need to develop the loss rate for each of those portfolio segments considering whether they only use the historical loss rate, if there needs to be a weighting to give more influence to current performance factors, or if data should be extrapolated. Then they need to look at the environmental factors that have a bearing on how the loan will perform. These factors include:
* Industry trends.
* Economic trends.
* Geographic issues.
* Political issues.
And finally, they need to determine a range of loss and the best estimate within that range for each of the pools.
Summary. A brief overview of the ALL methodology is to look at the portfolio first to identify those loans that will be evaluated under FAS 114 on an individual basis, and then to segment the remaining loans into pools and evaluate those under FAS 5. Although the approach is slightly different, we're still looking for impairment on those loans and estimable losses, whether it be in individual loans or in pools of loans.
