Now that we've mastered the art of calculating an appropriate ASC 450 (FAS 5) Reserve balance, it is time to take on a bigger challenge. And what could be a bigger challenge than developing a systematic and objective methodology to calculate the ASC 310 (FAS 114) reserve balance for your institution?
Well, getting your kids to stop texting while eating dinner ... probably. If you can do that, then ASC 310 will be child's play for you.
Defining Impaired Loans
The Interagency policy for ALLL states that the starting point for this calculation is the identification of all loans that are deemed to be potentially impaired. The search for the Holy Grail is probably a lot easier than getting the exact definition of an impaired loan.
To begin, the identification of these loans can come from an institution's "normal loan review procedures". However, the Guidance does not specify what that means. The translation of this language would suggest the inclusion of loans that meet some sort of a classified loan classification.
A financial institution is required to review each of its classified loans individually according to various criteria to identify "impaired" loans. Loans determined not to be impaired are returned to their pools for analysis under ASC 450 (FAS 5). In accordance with Inter-agency policy, loans which have been reviewed for impairment and where there is no quantitative measurement of impairment are not required to be returned to the ASC 450 (FAS 5) pool.
While the calculation of the actual reserve amount is rather easy for ASC 310 purposes (yes I said rather easy), the issue where most institutions get criticized, and where the process falls apart, is the first step of identifying potentially impaired loans. If the loan is not deemed to be impaired then it must be pushed back for ALLL calculation purposes into the ASC 450 (FAS 5) pool category.
Now I know the following sounds totally contrary to what I just said above:
"In accordance with Inter-agency policy loans which have been reviewed for impairment and where there is no quantitative measurement of impairment, those loans are NOT required to be returned to the ASC 450 (FAS 5) pool."
The key takeaway here is the issue of an institution's definition and assessment of what constitutes an impaired loan. We need to develop a definition and then apply it consistently. Thus a loan which we believe to be potentially impaired, and does not meet our definition of such, must be returned to the ASC 450 (FAS5) pool. This is different than taking a loan (which meets our definition of an impaired loan), measuring the amount of impairment and concluding that collateral value exceeds the loan balance. In this scenario such a loan does not need to be pushed back to the FAS 5 pool.
Based on my experience, this has been an area inconsistently applied in many regulatory exams, and the concept misunderstood the most by bank management.
Alas, we still have to develop a definition or methodology to identify impaired loans. You can get as scientific as you want. For those that want to keep it simple, I would suggest the inclusion of all loans on your non-accrual list. You can also use your loan classification risk rating closest to Substandard (to get bonus points) or Special Mention and above (if you really want mega-bonus points).
Don't get me wrong, the technical definition of Substandard or Special mention does not automatically indicate that a loan should be measured for individual impairment analysis. Traditionally, the payment history or the likelihood that borrower's inability to repay has been impaired is the general criteria. Thus loans classified as non-accrual should definitely qualify. If your institution has classified loans as Substandard and such are not on the nonaccrual list, you may want to review those loans to assess whether they should really be included in your review.
So why did I allude to loans rated as Special Mention above? Based on practical experience, what has become apparent is that many institutions do not have an adequate risk rating process. I will discuss that a little later.
The Interagency guidance states that an institution should rely on its normal loan review program for identifying impaired loans. Many community banks outsource their loan review function. So if an institution is going to rely on such a review it must assess the adequacy of the frequency of such a review; an annual review is not going to work anymore. If the identification of potentially impaired loans is tied to loan classification risk ratings, then an institution must ensure that those ratings are reviewed more frequently.
If you forget to change the frequency of your independent loan review program ... well, don't worry. Your friendly neighborhood regulators will include it in their next safety and soundness report.
ASC 310 (FAS 114) impairment measurement
Loans identified as "impaired" are those for which the Bank is unable to collect all amounts according to contractual terms. The Bank can estimate the amount of loss based on one of three approaches: present value of estimated future cash flows, fair market value of collateral for collateralized loans, and estimated market price of loan.
For an individually evaluated impaired collateral dependent loan, the regulators require that if the recorded amount of the loan exceeds the fair value of the collateral (less costs to sell if the costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan), this excess is included when estimating the ALLL. By now, most understand how to calculate the potential impairment amount. The contention during regulatory exams has been how one determines fair market value and what support an institution has to provide to support its fair market value assessment. The Q&A section of the Interagency policy actually provides some concrete guidance on that.
Some institutions, however, attempt to derive the estimated fair market value of the collateral property by taking the old appraisals in the loan file from the time of origination and discounting it based on their estimate of the decline in the property values in the particular area. This methodology, although reasonable, is often not well supported and has therefore not worked well with the regulators.
So what do the regulators want? They want a current bona fide appraisal. But that costs money and how can an institution pass this cost on to a borrower who is having a difficult time making normal payments as it is. So what happens? Many institutions procrastinate in getting an appraisal.
You can't procrastinate. While it doesn't say so anywhere, the regulatory expectancy is that an institution should set a time frame and a consistent framework to ensure that they are being performed in an objective, consistent and timely manner. I sound like your last regulatory exam report don't I? Well if you didn't have any issues in this regard you wouldn't be reading this.
One interesting thing that I have noted in working with many of our clients in the Northeast is that where institutions have maintained a conservative underwriting LTV policy, the ASC 310(FAS 114) analysis after current appraisal has determined that impairment is negligible. Thus, in such instances, the amount of reserve allocation (even including the cost of getting a new appraisal) has actually been lower than the amount of ASC 450 (FAS 5) ALLL reserve that would be required on such a loan without such an analysis. I think many institutions miss this concept and concentrate too much on the hard out-of-pocket cost.
The flip side of this is (there's always a flip side - otherwise it would be a breeze) if your appraisals consistently indicate that there is no impairment when comparing the recorded value with the loan to the current appraised value of the collateral (even taking into account selling costs, etc.), regulators will be skeptical and require you to further discount those appraised values because they want you to have a forward looking approach to the market value.
But wait...didn't we just get an appraisal to avoid this kind of subjectivity? So what we are being told is to make sure you get an appraisal that demonstrates impairment irrespective of the institution's conservative lending LTV policy, which is designed to protect the bank specifically against this type of a scenario.
So perhaps the lesson to be learned is to not have such a conservative LTV lending requirement; you're going to have to take the same hit as everyone else anyway. Of course, I didn't say that.
Loan Risk Classification Rating
The biggest challenge for institutions is to ensure that they are not surprised during their regulatory exam. If an important component of ALLL is tied to the identification of impaired loans which, in turn, are tied to your loan risk classification rating, then a regulatory exam which challenges those ratings can end up with a significant adjustment to your ALLL.
This is where I believe many institutions fall short. Their loan review programs do not adequately identify inherent risks consistent with the regulatory emphasis. Of course, it's an easy statement for me to make: how do you know what the regulatory emphasis is when it is not defined anywhere and keeps changing from one exam to another? Well that's another discussion ... for another time.
The only thing I can suggest is to develop an objective criteria for your internal loan risk classification ratings. Develop specific risk drivers, such as an assessment of borrower financial information, payment history, collateral value, debt service ratios, etc. Tie the movement, or your assessment of those drivers, to your loan rating. Obviously loan ratings can never be totally objective as individual situations will differ, but the more objective you can be, the less surprise you will have ... and the more you will be able to support your assessment. Thus loan reviews need to evolve to more quantification of data and assessment, rather than a subjective narrative assessment to support the loan ratings.
Charge Off or ALLL Reserve
Another area of much confusion has been whether the impaired portion of loan, once calculated, should be added to ALLL or charged off. The Interagency policy states that the portion of the impaired amount that an institution determines as being a loss and uncollectible should be charged off. So that means once you calculate your measurement of the impairment amount for each loan, you need to then further assess what portion of it is collectible and what portion is not. You cannot assume that all of it will be collectible and simply add it to the reserve. So you have to evaluate it on an individual case-by-case basis.
Naturally on a topic as diverse and complicated as ALLL, I have probably left out a lot of other issues you may have experienced of late. The abundant confusion on the topic certainly stems from many sources. From lack of internal knowledge due to almost no emphasis on such issues over the past 20 years, inconsistent and absent regulatory emphasis from Washington, vague and in concise regulatory policies, applying standards learned from institutions that were poorly managed to those that were not and unavailability of appropriate uniform benchmark data and risk indicators.
We can all pile on to this. However, one thing we can all agree upon is that we are undergoing some very tough and confusing times. All I can say is that when it comes to your ALLL methodology, you need not only be able to calculate the right number, but you need to be able to support it and provide your narrative.
After reading the first part of this blog topic, a client of mine wrote back saying that I picked the wrong painter. Originally, I had stated you can now be a Picasso as well. He appropriately corrected me and said, I should've picked da Vinci.
He had a good point ... the ALLL methodology is as complex, if not more, than the da Vinci Code itself.
Amit Govil, Managing Partner of P&G Associates, has over 25 years of experience serving the risk management needs of financial institutions