How to Justify a Change in Your ALLL
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The document outlines best practices for justifying changes in the allowance for loan and lease losses (ALLL), emphasizing the need for a comprehensive, well-documented, and consistently applied analysis. It details the factors that examiners consider important, such as qualitative and environmental risks, and provides statistics on recent ALLL trends, highlighting preparation strategies for financial institutions facing examinations. Resources and guidance from Sageworks are available to support institutions in improving their practices related to ALLL.
How to Justify a Change in Your ALLL
- 1. How to Justify a Change in Your ALLL Sageworks O - (919) 851-7474 | F - (919) 851-6718 info@sageworks.com www.sageworks.com
- 2. About Sageworks Financial information company that provides credit and risk management solutions to financial institutions Data and applications used by thousands of financial institutions and accounting firms across North America Provides resources, including whitepapers, webinars, videos, and templates, for bankers—accessible at www.sageworks.com 2
- 3. 1. What’s the Big Deal? 2. What Examiners are Looking for in the ALLL • Comprehensive • Well Documented • Consistently Applied • Inclusive of Environmental & Qualitative Risk Factors 3. Areas of Scrutiny 4. By the Numbers 5. 6 Ways to Prepare for your Next Exam 6. Q & A Agenda 3
- 4. Quick Poll 1. Quarterly Call Reports 2. Current ALLL Levels
- 5. What’s the Big Deal? 5
- 6. What’s the Big Deal? 6 1. Impact on bank earnings and therefore shareholders 2. Impact on capital and leverage ratios 3. Strict regulations surrounding the ALLL and specific guidance 4. Ability to absorb losses for the current year
- 7. What Examiners are Looking for in the ALLL 7 Allowance estimates should be based on a comprehensive, well-documented, and consistently applied analysis of the loan portfolio; and the loan loss allowance should take into consideration all available information existing as of the financial statement date, including environmental factors such as industry, geographical, economic, and political factors. 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses
- 8. Comprehensive ALLL 8 If you have the ability, move to a more sophisticated analysis De novo institutions changing from peer group loss rates to true historical loss rates after their de novo status ends Moving from historical loss rates to migration analysis Consider an automated software that provides more detailed analysis
- 9. Well Documented ALLL 9 Loss rate methodology Documenting peer groups and source of data Supporting the calculations Providing documentation and data to support qualitative factors Loan impairment analysis Including recent and accurate appraisal data Supporting expected cash flow assumptions
- 10. Consistently Applied ALLL 10 Consistent historical look-back periods Examiners allow institutions to calculate loss rates using multiple look-back periods in order to find the most conservative loss rates. But, changing look-back periods will limit the defensibility of the calculation. Consistent use of loss rate weightings If loss rate weightings are applied, make sure they are consistent. Consistent calculation of expected cash flow payment
- 11. Consistently Applied ALLL 11 Consistent historical look-back periods Examiners allow institutions to calculate loss rates using multiple look-back periods in order to find the most conservative loss rates. But, changing look-back periods will limit the defensibility of the calculation. Consistent use of loss rate weightings If loss rate weightings are applied, make sure they are consistent. Consistent calculation of expected cash flow payment However, improvements in the calculation may merit inconsistent If an institution moves to a more sophisticated model (e.g. migration analysis instead of historical loss rates), inconsistency from the prior period is acceptable.
- 12. Inclusive of Qualitative & Environmental Risk Factors 12 Utilize standard factors from Interagency Guidance Many are inherently subjective, but use quantitative support where possible Changes in Delinquency Changes in Collateral Values Economic Conditions Determine drivers for each factor Trend from previous quarter
- 13. Inclusive of Qualitative & Environmental Risk Factors 13 1. Changes in lending policies and procedures, including changes in underwriting standards and collections, charge offs, and recovery practices 2. Changes in international, national, regional, and local conditions 3. Changes in the nature and volume of the portfolio and terms of loans 4. Changes in the experience, depth, and ability of lending management 5. Changes in the volume and severity of past due loans and other similar conditions 6. Changes in the quality of the institution’s loan review system 7. Changes in the value of underlying collateral for collateral-dependent loans
- 14. Inclusive of Qualitative & Environmental Risk Factors 14 8. The existence and effect of any concentrations of credit and changes in the level of such concentrations 9. The effect of other external factors (i.e. competition, legal and regulatory requirements) on the level of estimated credit losses
- 15. Areas of Scrutiny 15 After a significant change in the ALLL, what areas will be viewed with greater scrutiny by examiners? 1. Showing adequate support for a reduction of the allowance due to improved qualitative factors 2. Studying impaired loan analysis for excessive optimism for cash flow expectations
- 16. By the Numbers 16 What is the average ALLL reserve rate? Decreased by 10 basis points, nationally. Time Period Average Reserve Rate 2013 Q2 1.81% 2013 Q1 1.86% 2012 Q4 1.84% 2012 Q3 1.88% 2012 Q2 1.91% Average from 5,915 banks that continuously reported for the past 4 quarters
- 17. By the Numbers 17 What was the average change in ALLL rates? Volatility may be decreasing slightly. Time Period Absolute Value of the Change Standard Deviation of the Change 2013 Q2 13 bps 26 bps 2013 Q1 12 bps 19 bps 2012 Q4 17 bps 32 bps 2012 Q3 14 bps 29 bps Average from 5,915 banks that continuously reported for the past 4 quarters
- 18. 6 Ways to Prepare for your Next Exam 18 1. Make use of market surveys and feedback (See Sageworks Bank and Credit Union Exam Survey) 2. Beef up documentation 3. Assure chosen loss rates and supporting data points for qualitative factors are directionally consistent 4. Be able to defend your chosen expected cash flow assumptions 5. Charge off loan once impairment is recognized 6. Use an automated solution that provides more detailed analysis
- 19. Quick Polls 1. ALLL content from Sageworks 2. ALLL solution from Sageworks
- 20. Questions? Additional whitepapers and archived webinars available at www.sageworks.com Featured whitepaper – How to Calculate your FAS 5 Reserves