As 2013 comes to a close, many financial institutions find themselves unsettled regarding their allowance for loan and lease losses (ALLL) methodologies . With the Financial Accounting Standard Board’s (FASB) proposed current expected credit loss model (CECL), banks will be required to “look ahead” in the estimation of credit losses and use of a “life of loan” expected, credit loss estimate. Thomas Curry, Comptroller of the Currency, estimated that with the potential change, reserves could increase anywhere from “30-50 percent.”
While banks continue to wait for the final release of the FASB’s CECL model, there are several key factors and steps that banks and credit unions should take into consideration while calculating year-end reserves.
Receiving accurate and reliable data has been a major challenge for banks calculating their reserves. Gathering data such as appraisal values, charge-offs or final months’ end reconciled numbers can delay the ALLL calculation. There are four types of data critical within ALLL:
- Loan portfolio information
- Collateral valuations and loan data for FAS 114 (ASC 310-10-35) calculations
- Historical loss data for FAS 5 (ASC 450-20) calculations
- Supporting data for qualitative adjustments to FAS 5 calculations
Since a significant amount of time is spent on the classification of FAS 5 (ASC 450-20) and FAS 114 (ASC 310-10) buckets, it is recommended to acquire as much loan-level detail for the basis of sound financial decisions and justification regarding ALLL reserves.
Historical loss rates are critical for determining ALLL reserves and can have a major impact on the overall firm’s methodology for determining FAS 5 impairment. While methodologies vary from bank to bank, it is common for community banks to use an 8-12 quarter look-back. However, with the economy improving, increased regulatory requirements and a refined lending methodology, banks have been able to strengthen their overall loan portfolio and in some cases justify a decrease in their ALLL reserves. In addition, while utilizing the 8-12 quarter look-back period, banks are seeing significant charge-offs from prior periods begin to fall-off from their FAS 5 loss ratios, an even bigger problem for banks that transitioned from the OTS to the OCC. Despite the improved economy and lending practices, regulators are still closely monitoring reserves especially in cases where they feel banks are under-estimating their reserves to boost overall earnings.
Thomas Curry explains, “It is to be expected” for some banks to reduce reserves. But, it is well-known that negative provisions and releasing of reserves can raise red flags at exam time.
Banks must be prudent and document historical data to justify their ALLL reserves, which is why the first year-end recommendation for banks and credit unions is to shore up data collection processes to provide for more granular analysis. Obtaining such data for the ALLL reserve calculation can be a time-consuming and error-prone process.
Archiving historical data and capturing loan level detail is essential for financial institutions in forecasting related loss reserves and explaining trends in recoveries, deviations from historical patterns, sensitivity to variation and trends in delinquencies. By storing key data, it will inherently support the institution’s overall ALLL, especially for banks utilizing a migration analysis model. Yet, banks working off spreadsheets through time find it difficult to track changes in data and are more prone to data manipulability, which can compromise the integrity of the derived analysis.
Many institutions have been able to streamline the process by utilizing automated systems that integrate with a bank’s core to project ALLL reserves before quarter-end and even automate for up-to-date balances.
By using third-party vendors, banks are able to archive historical data information, eliminate the cascading effect over spreadsheets, increase consistency, provide defensibility and help prepare for future policy changes through greater data granularity.
The second recommendation for year-end ALLL calculations also pertains to data but, more importantly, to how that data is accessed and reported on through disclosure reports.
With the release of the July 2010 FASB Accounting Standards Update 2010-20, banks increased transparency pertaining to financial reporting. Robert H. Herz, the FASB chairman, stated: “The global financial crisis highlighted the need for additional information about a company’s financial instruments, including loans and other financing receivables. This Update proves greater transparency for investors and other users of financial statements by requiring more information from companies about credit risk exposure for financing receivables and the related credit reserves.”
The additional disclosure reports required for financing receivables are as follows:
- Aging of past due receivables
- Credit quality indicators
- The landscape and extent of troubled debt restructurings and its impact on the allowance for credit losses
- Significant purchases and sales of financing receivables
Under the guidance, banks need to disaggregate new and existing disclosures based on how the bank develops its allowance for credit and losses as well as how it manages credit risk. As of December 15, 2010, public banks were required to follow the new disclosure reporting standards while private banks had until December 15, 2011. Furthermore, public banks are expected to provide interim and year-end disclosures whereas private banks need only to generate disclosure reports on an annual basis. For private banks, this has become a tedious and cumbersome process due to the necessary loan-level detail and trends required, and banks may struggle with retaining, storing and documenting critical information since it is only being required on a yearly basis. For example, banks will need to deliver an in-depth Troubled Debt Restructuring report by loan class as well as a report for any TDR defaults in the past 12 months and its impact on the ALLL reserve. If private banks are not taking the initiative to keep thorough and detailed records throughout the course of the year, constructing disclosure reports can be extremely burdensome.
Nick Shakarjian is a director at Sageworks.