Your Allowance for Loan Loss Calculation and Compliance with Interagency Statement (FIL 105-2006) in 6 Easy Steps

STEP 1 - Analyze the qualitative factors impacting the loan portfolio
Before reviewing individual loans in your portfolio you must identify and analyze the qualitative factors which impact asset quality. The Interagency Statement provides a list of factors which include, but are not limited to:

• Changes in lending policies and procedures
• Changes in national, regional, and local economic and business conditions
• Changes in the value of underlying collateral for collateral based loans
• The existence and effect of concentrations, and changes in concentrations
• Changes in the nature and volume of the loan portfolio (including trends past dues, classified loans, and nonaccrual loans)

Refer to the statement for additional factors for consideration. Management’s consideration of these factors must be documented. One source of information for economic data is the FDIC’s Regional Economic Conditions reports.

In addition a narrative discussion would be beneficial to perform various analytic procedures to provide additional analysis of trends in the portfolio. This analysis may include the following:

1. An analysis of trends in the internal loan grades
2. A trend analysis of several nonaccrual, past due, and charge-off ratios
3. A peer trend analysis of allowance, charge-off, and nonaccrual ratios
4. Concentration trend analysis
5. Trend analysis of technical exceptions identified during independent loan reviews (only exceptions which could impact asset quality)

These considerations can be useful in determining the reasonableness of allocation percentages, the determination of impaired loans, and whether or not an adjustment is necessary to the determined range of the ALLL.

Example - Trend in Internal Loan Grades

STEP 2 - Questions/Thoughts to Consider for FAS 114 Calculation
Does the Bank expect to collect principal and interest in full? A YES answer indicate the loan is not impaired and will, therefore, be pooled with similar loans in the FAS 5 section. A NO answer would lead you to the next question below.

Would the shortfall of the loan be insignificant? A YES answer would put the loan into a pool of classified loans. A NO answer would make the loan subject to FAS 114 impaired loans calculation.

Loans internally graded with a substandard or below risk grade are evaluated in Step 2. Each loan is calculated on a specific reserve in accordance with FAS114.

STEP 3 - Questions/Thoughts to Consider for FAS 5 Pool Calculation

• Do all loans downgraded by the 3rd party loan review or in-house loan review contain the latest loan grade change?
• Loans graded substandard or below, by default, could be considered impaired and a different ratio for these types of loans may be more appropriate.
• Are your risk grade percentages appropriate and supported by appropriate factors?
• An example of a factor that can be utilized in computing the required reserve for the classified loan pool can be the high, low or average of the ratio of net charge-offs to average non-accrual loans, historical charge-off percentages or industry information that mirrors your loan portfolio.

STEP 4 - Questions/Thoughts to Consider for FAS 5 Unclassified Calculation
Are the loan categories the Bank uses too broad on which to estimate loss?

Reserve Percentages as computed by loan type could be the historical average industry information, or the high or low of the ratio of net charge-offs to loan type.

Are they based on historical experience? Has something changed at the Bank or its environment that makes historical experience irrelevant?

It is important to not only consider concentrations by loan type but also concentrations by borrowers or related borrowers.

Does what you see make sense to you from your own knowledge and experience and the quantitative and qualitative analysis completed in the previous steps?

STEP 5 - Questions/Thoughts to Consider for Summary Calculation
Is the calculated required reserve within the acceptable ALLL range set by the Board?

Is the range set by the Board an appropriate range or is there historical, current and/or environmental implications which would indicate a change in the range or range methodology?

If NO, an adjustment has to be made to the actual reserve.

Loan portfolio trend analysis quantitative evaluations and qualitative evaluations can assist you in making the determination of a range for the overall ALLL computations. Other factors may need to be considered including your internal control structure, changes in lending policies, etc.

STEP 6 - Continuous Review and Independent Validation
The various considerations and calculations performed by management in the preceding steps should be reviewed by the Loan Committee on at least a quarterly basis, and by the Board of Directors at least annually. Any changes to the methodology or its application should be approved by both the Loan Committee and/or the Board of Directors. The Interagency Statement requires a periodic validation of the ALLL methodology and application by someone independent of the credit approval and ALLL estimation process

We have available a full, more detailed, PDF version of an ALLL model that is available upon request, and we also would enjoy hearing from you regarding your questions about this ALLL Model. Please contact one of our offices to discuss these items further.

Contact Nichols, Cauley & Associates by Email, phone, or online form with your questions.

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