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Staying on top of the allowance for loan and lease losses (ALLL) is critical for banks, especially in the current economy. If examiners find that your ALLL is underfunded, they may downgrade your bank’s CAMEL rating, require you to increase capital levels or take other remedial action.

One of the biggest challenges in calculating the ALLL is assessing the impact of qualitative, or “environmental,” factors. These are factors that cause your bank’s loss estimates to deviate from its historical loss experience. Interagency guidance provides a useful outline for this analysis, but will examiners expect you to go further?

Agencies issue guidance

Federal banking agencies published their Interagency Policy Statement on the ALLL in 2006. According to the policy statement, the starting point in measuring the ALLL is to “determine the historical loss rate for each group of loans with similar risk characteristics in its portfolio.” Next, management should consider qualitative factors likely to cause the bank’s estimated credit losses to differ from historical losses. These factors include changes in:

• Lending policies and procedures
• Business conditions (on an international national, regional or local level)
• Loan volume, terms or profiles
• The lending staff’s experience, ability or depth
• The volume or severity of problem loans
• Loan review quality
• Collateral values
• Credit concentration levels

Banks also should consider other external factors, including competition and legal and regulatory requirements.

Examiners suggest best practices

In a recent SRC Insights article, “Qualitative Factors and the Allowance for Loan and Lease Losses in Community Banks,” authors Sharon Wells and Trevor Gaskins, examiners with the Federal Reserve Bank of Philadelphia, reported observing a number of weaknesses in banks’ ALLL methodologies. One of the biggest problems they saw was inadequate portfolio segmentation.

The interagency policy statement instructs banks to group loans with similar risk characteristics, but many banks segment their loan portfolios into overly broad categories, which may not accurately reflect underlying risk factors. Depending on a bank’s size, and the nature and scope of its lending activities, it may be appropriate to segment the loan portfolio into narrower categories.

Another area where banks fall short is the examination of qualitative factors. Too often, banks limit their analysis to the broad factors outlined in the policy statement. According to the authors, however, a best practice is to “prepare an institution-specific and customized risk assessment of each portfolio sector based upon the unique characteristics and loss drivers of that loan portfolio.” The article contains a detailed list of loss drivers that banks should consider in conducting their analyses.

Finally, the article warns banks that their valuation of qualitative factors affecting the ALLL must be supported, documented and not overly dependent on subjective opinion.

Review your ALLL methodology

To ensure that your bank’s ALLL is adequately funded, review your methodology in light of the guidance described above. Your advisors can help you design ALLL policies and procedures that accurately reflect your bank’s unique risk profile.

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