How do we define an adequate level of ALLL reserve? Alas, that is the new $64 question in the banking industry. The ALLL Reserve is apparently like a priceless art piece, which is subject to significant scrutiny and different interpretations.
Based on recent regulatory emphasis, the changes in the economic climate, the uncertainty in the real estate market and the economy have all cumulated into the most confusing and erratic environment regarding the establishment of a bank's ALLL Reserve. The regulatory scrutiny has been tremendous. Of course, along with such scrutiny brings an element of inconsistency which is derived primarily by the regulatory desire to increase the ALLL Reserve. Such desire is often in direct conflict with the Bank's, whose main objective is to not only maintain an adequate reserve balance but also to preserve earnings and capital levels.
The 2006 Inter-agency Policy Statement on Allowance for Loan and Lease Losses combines with other regulatory and accounting directives to establish guidelines and requirements for the accounting of projected loan losses and determining loan loss reserves.
So what's the problem? Where does this subjectivity come from? The problem is that these requirements and guidelines are themselves pieces of art subject to varying interpretations. One would think that all of these regulations would be able to create a concise and simple formula that all parties could be content with. But then we'd have nothing to complain about. Now at least we can blame someone else who doesn't see the glass as half full and insists that it's half empty.
The directives require banks to implement a consistent and verifiable method for determining ALLL - and be able to demonstrate that their process results in a reasonable and justifiable loan loss reserve. The Inter-agency policy requires banks to approach the ALLL reserve calculation using two distinct perspectives, the guidelines of using Financial Accounting Standards (FAS) No. 5 (Accounting for Contingencies, for grouped loans) and FAS No. 114 (Accounting by Creditors for Impairment of a Loan, for individual loans).
To complicate matters further, the Financial Accounting Standards Board (FASB) recently released the Accounting Standards Codification. So now we all we have to get used to saying ASC 450 for FAS 5 and ASC 310 for FAS 114. This happened, of course, just as we all discovered that there's indeed a FAS114. I didn't know they went that high. So I'll try to use them going forward in this blog, although I can't promise that I will be able to correctly.
But as is any good art form, the beauty is in the eye of the beholder. The issue in many cases that I see is not even the dollar amount of the ALL reserve, but being able to substantiate it.
The ASC 450 (I got it right, FAS 5) is perhaps where the greatest challenge with respect to documentation comes in. The guidance tells you the following:
I wonder what will happen when the charge offs start to decline - will we have to revert back to a five year history? Hmmm!
I'm sure it's there somewhere. I need glasses but have just been pretending that I don't. When I get my new glasses and find it, I'll let you know.
Off balance sheet items (i.e. unfunded credit lines, loan commitments, etc.) - if you follow the interagency and GAAP guideline, the answer would be no. The regulatory emphasis says yes. So I would say YES.
In the case of loans for which an ASC 310 impairment measurement review has been performed (these would be loans which you have determined are impaired and have measured the potential impairment, even if it is none) - if you follow the Interagency guideline the answer is no. The regulatory emphasis says maybe, it depends.
So what do I say? In a bit of defiance, I say "no". The inconsistency from the regulators, I believe, stems from their confidence level on the bank's ASC 310 review process. The stronger and more objective the process, the more they are inclined to agree with me (imagine that). We'll discuss more of that in Part 2 of this masterpiece of a blog (I know you can't wait).
So to summarize, the ASC 450 reserve balance is derived by:
So now you can be the new Picasso. Good Luck.
(Read Part 2, "Cracking the Code: How to Develop the Right FAS 114 Methodology" here)
Amit Govil, Managing Partner of P&G Associates, has over 25 years of experience serving the risk management needs of financial institutions