Plan for Today, Look Ahead to Tomorrow’s Allowance for Loan Losses (ALL)

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At the North Carolina Bankers Association’s 2015 Bank Directors Assembly, held March 2 and 3 in Greensboro, N.C., Walter McNairy gave a presentation entitled, “What Your Regulators Are Saying about the ALL – Today and Tomorrow.”  The following is a summary of the key points that have been raised by bank regulators regarding both today and tomorrow’s ALL.

Today’s ALL

Quantitative Reserve

GAAP does not prescribe a fixed period of time for historical loss experience. Changes to historical look-back periods should be thoroughly documented, and management should analyze how current conditions compare to those during the period used. Minimum loss rates are to be used for short-term only – then use the bank’s actual loss history adjusted for qualitative factors.

Qualitative Factors

Qualitative factors must be supported, and such support can include:

  • Economic data
  • News articles
  • Notes from borrower discussions
  • Bank’s own credit quality trends

Document your conclusions, including factors that are not used. Keep in mind factors that address geography, staffing and lending practices. Also, consider recent changes relating to:

  • Home Equity Line of Credit (HELOC) exposure
  • Indirect auto lending
  • Earnings pressure that may lead to loosening of underwriting standards

Examiners also will look for directional consistency between loss estimates and the underlying factors.

Negative Provisions

Discuss any anticipated ALL releases with your primary regulator in advance – no surprises. The documentation needs to demonstrate the rate of change in the ALL is reasonable, compared to the rate of change in asset quality, and that the releases are well supported, documented and reasonable.

Other Areas

Unallocated reserves are OK without a limit on the amount, but they must be properly supported and documented.

All banks need an effective appraisal review process, and any discounts to appraisals should be supportable and applied consistently.

The ALL model should be validated by an independent party.

Tomorrow’s ALL

The current expected credit loss (CECL) model has been proposed by FASB but is not finalized yet. The impact of CECL will change the following:

  • No more probable threshold
  • No more impaired loan accounting
  • For purchase credit impaired (PCI) loans, ALL to be established at acquisition
  • Need to consider reasonable and supportable forecasts that affect future cash flows

Bank regulators have noted several implementation observations:

  • Scale model to the size of the institution
  • Leverage existing processes and methodologies
  • Consider now what you will need later
    • Vintage loss history
    • Convert annualized charge-off rates to remaining lifetime net charge-off rates
    • Start collecting as much data as possible now on loan losses / charge-offs
    • Consider capital adequacy
  • Keep your regulator up-to-date
  • Implementation no no’s:
    • No early incorporation of expected loss concepts
    • No artificial inflation of the ALL to smooth impact upon adoption
    • Do not wait to prepare
    • Do not overload at adoption (no cookie jar reserves)

To prepare today, your institution can take the following steps:

  • Understand the new CECL requirements
  • Compile as much loss data as you can, in as much detail as you can, as far back as you can
  • Determine correlation of losses to general economic data, specific risks, etc.

The Bottom Line

Regulators will look for solid support for every component of your methodology. Discuss any significant changes with your auditors and regulators, and for CECL, start preparing now by analyzing historical loss trends as far back as possible.


About the Author

Walter McNairy, Managing Partner, DHG Financial Services, oversees financial services client engagements throughout DHG’s footprint. Over the past 25 years Walter has worked with community, regional and top 10 banks helping them achieve their strategic goals and navigate the complexities inherent in today’s environment.

Contact Walter or your local DHG Financial Services professional for additional information:

Walter McNairy, Managing Partner, DHG Financial Services or 919.875.4993


About DHG Financial Services

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