A bank’s Allowance for Loan Loss is a perennial hot button issue amongst both state and federal regulatory agencies. It is, without a doubt, one of the most detailed and high risk audits our firm conducts. It’s a complex animal; figuring the Bank’s reserve requirements based on the Interagency guidance, presenting it in a manner that justifies the Bank’s number, satisfying the regulators, and most importantly, doing it all so that it does not take so much of your time that you feel like it is all you do. This is made more complex by the seeming shift in scrutiny from the amount reserved to the methodology behind it.
Throughout my travels as both internal auditor and manager, I have seen at least 60 unique methodologies that attempt to hit that magic sweet spot of presentation and time sink avoidance. The best ones contain four key elements that put the data into a package that is sensible and doesn’t appear to be a sequel to War and Peace.
Stick to the Program
The interagency guidance has a blue print on what needs to be laid out for your ALLL. Pool your loans into categories that make sense, measure them for historical loss, and then test them against the qualitative factors and viola - you have your ASC 450 component. Sprinkle in the impaired loans, do the math, and you have an Allowance that adheres to the guidelines. What we sometimes find, however, is a variation on this theme. And while sometimes it’s good to think out of the box, in this case you should stay in the box, tape the lid and place a “do not open ‘til Xmas” label on it. Any deviation from the guidance (extra reserve amounts taken for abundance of caution, reserves for watch or special mention, returning loans measured for impairment back to their respective pools, etc.) invites instant scrutiny and probably earns a comment in a regulatory report. Bottom line, it’s their game…play by their rules.
Show your work
In the same vein, it is no longer acceptable to have a one page spreadsheet that totals the numbers and gives the final figures as your Allowance presentation. The regulators want to see where these numbers came from, and whether they actually make sense. How did you come up with your historical loss percentages? What source did you use? Did you apply the qualitative factors across the entire spectrum, or to each individual pool? (pro tip – generalization is bad.) And regarding those qualitative factors - how did you arrive at those percentages? Documenting where these figures came from will answer a lot of the regulators’ questions before they ask. The devil really is in the details.
Narrate now, explain less later
The best methodologies I see out there contain a narrative of the above. While this is a time consuming component, it will save time when the Safety and Soundness questions start. Having a concise, thorough story of the thought process behind the Bank’s ALLL is something that is definitely being looked for nowadays. And since it’s a requirement of the interagency guidance to present the ALLL to the BOD and have them discuss and approve it, this narrative will give them something much more digestible than the charts and graphs and chicken entrails that went into making it. I don’t have a magic bullet for the length – you’ll know it when you see it on paper.
Tie it all together
Having the best methodology on the planet is great. But you would be surprised how many banks don’t have what they do describe in their policy. Many times when we perform a first time ALLL audit we see the “boiler plate” language and nothing more. Your loan policy is a blueprint on how the bank operates, and it should reflect your methodology accordingly. Here are some key aspects that the Firm looks for when we review a bank policy for ALLL –
Having the above as the framework for your ALLL policy will at least ensure the Bank is covering all the key points that are necessary to document the Bank’s process and controls for its Allowance function.
No matter what preparation and documentation you provide, the ALLL is still a minefield that a bank navigates though the regulatory minefield with a blindfold on. Hopefully, the suggestions above will loosen it a little so you and your colleagues can peak a bit.
Manager, Lending and Lending Compliance
Thomas LaChac is Manager of P&G Associatesâ€™ Lending and Lending Compliance team, and brings a wide range of experience in regulatory underwriting, quality assurance, regulatory compliance management and the banking and mortgage industries.