Allowance for Loan and Lease Losses - FMS Inc for loan and lease losses Simplified view of the FAS 5 allowance computation FAS 5 Reserve [ Loan Category Balance ] Historical Charge

Allowance for Loan andLease LossesMonday, June 17, 2013 9:10 AM-10:10 AM

Presented by:Jamie MayerManaging DirectorGrant Thornton LLP175 West JacksonChicago, IL 60604P: 312-602-8766E:[email protected]

www.fmsinc.org | 800-ASK-4FMS

Presented by:Jamie MayerManaging DirectorGrant Thornton LLP175 West JacksonChicago, IL 60604P: 312-602-8766E:[email protected]

DisclaimerThis presentation is not a comprehensive analysis ofthe subject matters covered and may include proposedguidance that is subject to change before it is issued infinal form. All relevant facts and circumstances,including the pertinent authoritative literature, need tobe considered to arrive at conclusions that comply withmatters addressed in this presentation. The views andinterpretations expressed in the presentation are thoseof the presenters and the presentation is not intended toprovide accounting or other advice or guidance withrespect to the matters covered.


This presentation is not a comprehensive analysis ofthe subject matters covered and may include proposedguidance that is subject to change before it is issued infinal form. All relevant facts and circumstances,including the pertinent authoritative literature, need tobe considered to arrive at conclusions that comply withmatters addressed in this presentation. The views andinterpretations expressed in the presentation are thoseof the presenters and the presentation is not intended toprovide accounting or other advice or guidance withrespect to the matters covered.

slide 2

Agenda• Allowance for loan and lease losses

– Basic concepts– Common issues– Best practices– Regulatory views

• Troubled debt restructurings


• Allowance for loan and lease losses– Basic concepts– Common issues– Best practices– Regulatory views


slide 3

Allowance for loan and lease lossesBasic concepts• A loss should be estimated and accrued by a charge to

income when both (ASC 450-20-25-2):– information available before the financial statements

are issued or are available to be issued indicates that itis probable that an asset had been impaired at the dateof the financial statements

– the amount of the loss can be reasonably estimated• A loan is impaired when, based on current information and

events, it is probable that a creditor will be unable tocollect all contractual principal and interest as scheduledin the loan agreement (ASC 310-10-35-10)


• A loss should be estimated and accrued by a charge toincome when both (ASC 450-20-25-2):– information available before the financial statements

are issued or are available to be issued indicates that itis probable that an asset had been impaired at the dateof the financial statements

– the amount of the loss can be reasonably estimated• A loan is impaired when, based on current information and

events, it is probable that a creditor will be unable tocollect all contractual principal and interest as scheduledin the loan agreement (ASC 310-10-35-10)

slide 4

Allowance for loan and lease lossesBasic concepts, continued• The ALLL is an estimate of loan losses incurred from

inception of the loan (or acquisition) up to the date of thefinancial statements, reduced by losses confirmed andcharged off.

• Losses are usually not immediately known. It takes timefor the borrower and extent of loss to be identified anddetermined. Thus, the ALLL is an estimate.

• The estimate is usually based on past experience with theborrower and/or loan type, adjusted for current events andconditions.


• The ALLL is an estimate of loan losses incurred frominception of the loan (or acquisition) up to the date of thefinancial statements, reduced by losses confirmed andcharged off.

• Losses are usually not immediately known. It takes timefor the borrower and extent of loss to be identified anddetermined. Thus, the ALLL is an estimate.

• The estimate is usually based on past experience with theborrower and/or loan type, adjusted for current events andconditions.

slide 5

Allowance for loan and lease lossesOverview

FAS 5(ASC 450)

FAS 114(ASC 310-10-35)


FAS 114(ASC 310-10-35)

SOP 03-3(ASC 310-30)

Total Allowance

slide 6

Allowance for loan and lease lossesSimplified view of the FAS 5allowance computation

FAS 5 Reserve [ Loan CategoryBalance ]

HistoricalCharge off Rate

AdjustmentFactor

[ LossDiscoveryPeriod ]

(type & grade)


AdjustmentFactor

Loan trialbalance

• Charge off policy and process• Charge off tracking in relation to

prior risk grading of loans• Risk grade process• Aging / re-aging process of loans• Collateral valuation process

Economicanalysisprocess

Loss periodanalysisprocess

Lossevent C/O

(Past due date)watch list

Loan officershould know

Loss suspectedloan reviewsslide 7

Qualitative and environmentalfactors (2006 Interagency policystatement on ALLL)• Changes in lending policies and procedures• Changes in economic and business conditions• Changes in the nature and volume of the portfolio and in the terms of loans• Changes in the experience, ability, and depth of lending management and

other relevant staff• Changes in the volume and severity of past due loans, the volume of

nonaccrual loans, and the volume and severity of adversely classified orgraded loans

• Changes in the quality of the institution’s loan review system• Changes in the value of underlying collateral for collateral-dependent loans• Existence and effect of any concentrations of credit, and changes in the

level of such concentrations• Effect of other external factors such as competition and legal and regulatory

requirements on the level of estimated credit losses in the institution’sexisting portfolio.


• Changes in lending policies and procedures• Changes in economic and business conditions• Changes in the nature and volume of the portfolio and in the terms of loans• Changes in the experience, ability, and depth of lending management and

other relevant staff• Changes in the volume and severity of past due loans, the volume of

nonaccrual loans, and the volume and severity of adversely classified orgraded loans

• Changes in the quality of the institution’s loan review system• Changes in the value of underlying collateral for collateral-dependent loans• Existence and effect of any concentrations of credit, and changes in the

level of such concentrations• Effect of other external factors such as competition and legal and regulatory

requirements on the level of estimated credit losses in the institution’sexisting portfolio.

slide 8

Environmental factors(SEC SAB 102)• Levels of and trends in delinquencies and impaired

loans• Levels of and trends in charge-offs and recoveries• Trends in volume and terms of loans• Effects of any changes in risk selection and

underwriting standards, and other changes in lendingpolicies, procedures, and practices

• Experience, ability, and depth of lendingmanagement and other relevant staff

• National and local economic trends and conditions• Industry conditions• Effects of changes in credit concentrations


• Levels of and trends in delinquencies and impairedloans

• Levels of and trends in charge-offs and recoveries• Trends in volume and terms of loans• Effects of any changes in risk selection and

underwriting standards, and other changes in lendingpolicies, procedures, and practices

• Experience, ability, and depth of lendingmanagement and other relevant staff

• National and local economic trends and conditions• Industry conditions• Effects of changes in credit concentrations

slide 9

Allowance for loan and lease lossesFAS 5 common questions/issues

• Are those the only factors one needs to consider?• Does a bank need to have an adjustment factor for

each suggested adjustment factor?• Can a bank have a negative adjustment factor?• Does the adjustment factor always need to be

defined in basis points?• Does a bank only need to support the change in the

adjustment factor or the entire adjustment factor?• Is an "unallocated allowance" appropriate?• Can we simply look to our peers?


• Are those the only factors one needs to consider?• Does a bank need to have an adjustment factor for

each suggested adjustment factor?• Can a bank have a negative adjustment factor?• Does the adjustment factor always need to be

defined in basis points?• Does a bank only need to support the change in the

adjustment factor or the entire adjustment factor?• Is an "unallocated allowance" appropriate?• Can we simply look to our peers?

slide 10

Allowance for loan and lease lossesLoss discovery period

Loss events culminatein the borrower’sinability to repay theloan.

The borrower begins tomiss payments, andproblems becomeevident to the lender.

The lender hassufficient informationto confirm the loss andtake the charge-off.


Loss discovery period

Performance continues sothat the loss is not visible.

Performance deterioratesso that the loss becomesvisible to the lender.

slide 11

Allowance for loan and lease lossesWhat impacts the loss discoveryperiod?• Nature and type of loan

– Commercial real estate vs. commercial– Asset based vs. unsecured– Owner occupied vs. investors/developers loans

• Loan terms– Interest only vs. P&I monthly

• Underwriting / pricing• Loan administration process

– Frequency and nature of contact with borrower– Collection of third party credit information– Loan covenants

• Loan review function• Charge-off policy


• Nature and type of loan– Commercial real estate vs. commercial– Asset based vs. unsecured– Owner occupied vs. investors/developers loans

• Loan terms– Interest only vs. P&I monthly

• Underwriting / pricing• Loan administration process

– Frequency and nature of contact with borrower– Collection of third party credit information– Loan covenants

• Loan review function• Charge-off policy

slide 12

Allowance for loan and lease lossesExample

• Bank has a portfolio of CRE loans totaling $10 billionthat have not been individually identified as impaired

• Adjusted charge-off rate is 2%• Loss confirmation period is 2 years


• Bank has a portfolio of CRE loans totaling $10 billionthat have not been individually identified as impaired

• Adjusted charge-off rate is 2%• Loss confirmation period is 2 years

FAS 5 Reserve [ Loan categorybalance ]

[ Loss discoveryperiod ]

Adjustedhistorical

charge-off rate

$10 billion 2% 2 years$400 million

slide 13

Allowance for loan and lease lossesFAS 114 Estimation Components

Loan by LoanAnalysis

• Measure theimpairment inaccordance with SFAS114

• Estimate impairment byeither:- FV of collateral less

cost to sell if loan iscollateral dependentOR

- Present value ofexpected cash flows

Loans Determinedto be Impaired


• Measure theimpairment inaccordance with SFAS114

• Estimate impairment byeither:- FV of collateral less

cost to sell if loan iscollateral dependentOR

- Present value ofexpected cash flows

CollateralValuation Function

LoanAdministration Loan Review

Loans NotImpaired Remainin FAS 5 Pools

slide 14

Allowance for loan and lease lossesSources for identifying impairedloans• Internally generated listings such as

– Watch lists– Past due reports– Overdraft listings– Loans to insiders– Nonaccrual loans– Restructured loans (not just TDRs)– Loan concentrations– Loans with non-standard payment terms (i.e. interest reserves)

• Historical loss experience by type of loan or risk rating• Results of loan review, internal audit and compliance reviews• Loans to borrowers in industries or countries experiencing economic

instability• Inquiries of relationship manager• Understanding changes in underwriting and collection policies


• Internally generated listings such as– Watch lists– Past due reports– Overdraft listings– Loans to insiders– Nonaccrual loans– Restructured loans (not just TDRs)– Loan concentrations– Loans with non-standard payment terms (i.e. interest reserves)

• Historical loss experience by type of loan or risk rating• Results of loan review, internal audit and compliance reviews• Loans to borrowers in industries or countries experiencing economic

instability• Inquiries of relationship manager• Understanding changes in underwriting and collection policies

slide 15

Allowance for loan and lease lossesOther issues

• Releases of the ALLL• Yield/earnings pressure• New/less familiar loan products• HELOCs• Junior/second lien loans• Outdated appraisals• CRE risk remains elevated

– Difficult workouts– Modifications, interest-only structures– Risk rating accuracy


• Releases of the ALLL• Yield/earnings pressure• New/less familiar loan products• HELOCs• Junior/second lien loans• Outdated appraisals• CRE risk remains elevated

– Difficult workouts– Modifications, interest-only structures– Risk rating accuracy

slide 16

Allowance for loan and lease lossesBest practices

• Document, document, document!• ALLL estimates should be based on comprehensive,

well-documented, and consistently applied analysisof the loan portfolio

• The ALLL should take into consideration all availableinformation as of the financial statement date,including environmental factors such as industry,geographical, economic, and political factors

• Arriving at an appropriate ALLL involves a highdegree of management judgment and results in arange of estimated losses


• Document, document, document!• ALLL estimates should be based on comprehensive,

well-documented, and consistently applied analysisof the loan portfolio

• The ALLL should take into consideration all availableinformation as of the financial statement date,including environmental factors such as industry,geographical, economic, and political factors

• Arriving at an appropriate ALLL involves a highdegree of management judgment and results in arange of estimated losses

slide 17

Allowance for loan and lease lossesBest practices, continued• Historical loss history is only the starting point in

determining "FAS 5" adjustments– Must understand what historical loss data is and is not

capturing– Incorporate all internal and external factors that would

likely cause estimated credit losses to differ fromhistorical loss experience

• Consider whether changes in the environment or otherfactors warrant a change in the ALLL methodology

• ALLL methodology should not be overly mechanical– Step back and ask whether the methodology and

process is resulting in an appropriate ALLL


• Historical loss history is only the starting point indetermining "FAS 5" adjustments– Must understand what historical loss data is and is not

capturing– Incorporate all internal and external factors that would

likely cause estimated credit losses to differ fromhistorical loss experience

• Consider whether changes in the environment or otherfactors warrant a change in the ALLL methodology

• ALLL methodology should not be overly mechanical– Step back and ask whether the methodology and

process is resulting in an appropriate ALLLslide 18

Allowance for loan and lease lossesUses of metrics/ratio analysis inALLL• Ratio analysis is a supplemental tool for evaluating

overall reasonableness of ALLL– May identify additional issues or factors that previously had

not been considered in the ALLL estimation process, whichmay warrant adjustments to ALLL.

– Inappropriate to make adjustments to the ALLL when it hasbeen properly computed and supported under theinstitution’s methodology for the sole purpose of reporting anALLL that corresponds to the peer group median, a targetratio, or a budgeted amount

• Generally, ratio's should be computed at a moregranular basis than total loans


• Ratio analysis is a supplemental tool for evaluatingoverall reasonableness of ALLL– May identify additional issues or factors that previously had

not been considered in the ALLL estimation process, whichmay warrant adjustments to ALLL.

– Inappropriate to make adjustments to the ALLL when it hasbeen properly computed and supported under theinstitution’s methodology for the sole purpose of reporting anALLL that corresponds to the peer group median, a targetratio, or a budgeted amount

• Generally, ratio's should be computed at a moregranular basis than total loans

slide 19

Agenda• Allowance for loan and lease losses

– Basic concepts– Common issues– Best practices– Regulatory views



• Allowance for loan and lease losses– Basic concepts– Common issues– Best practices– Regulatory views


slide 20

Troubled debt restructuringsBasic concepts

• A debt restructuring is a TDR if both (ASC 310-40-15-5):– Borrower is experiencing financial difficulties– Creditor has granted a concession to the borrower

• Evaluate based upon individual facts and circumstancesand requires judgment– A creditor should consider all aspects of a

restructuring to determine whether it has granted aconcession

– Creditor may conclude that a debtor is experiencingfinancial difficulties, even though the debtor is notcurrently in payment default


• A debt restructuring is a TDR if both (ASC 310-40-15-5):– Borrower is experiencing financial difficulties– Creditor has granted a concession to the borrower

• Evaluate based upon individual facts and circumstancesand requires judgment– A creditor should consider all aspects of a

restructuring to determine whether it has granted aconcession

– Creditor may conclude that a debtor is experiencingfinancial difficulties, even though the debtor is notcurrently in payment default

slide 21

Troubled debt restructuringsPractice issues

Are TDR's considered impaired loans?Quick answer - Yes• A loan is impaired when, based on current information and

events, it is probable that a creditor will be unable to collect allamounts due according to the contractual terms of the loanagreement (both principal and interest will be collected asscheduled). (ASC 310-10-35-16)

• For a loan that has been restructured in a troubled debtrestructuring, the contractual terms of the loan agreement refersto the contractual terms specified by the original loanagreement, not the contractual terms specified by therestructuring agreement (ASC 310-40-35-8)


Are TDR's considered impaired loans?Quick answer - Yes• A loan is impaired when, based on current information and

events, it is probable that a creditor will be unable to collect allamounts due according to the contractual terms of the loanagreement (both principal and interest will be collected asscheduled). (ASC 310-10-35-16)

• For a loan that has been restructured in a troubled debtrestructuring, the contractual terms of the loan agreement refersto the contractual terms specified by the original loanagreement, not the contractual terms specified by therestructuring agreement (ASC 310-40-35-8)

slide 22

Troubled debt restructuringsPractice issues, continuedAre loans restructured in a TDR always considered animpaired loan which must be accounted for under FAS114?• Yes, these loans stay in the individually evaluated for

impairment bucket permanently– No FAS 5 allowance permitted, impairment

measured under FAS 114• Discussed by FASB Board on January 30, 2008

– Some FASB Board members indicated that it maybe permissible to group loans under a FAS 114approach (ASC 310-10-35-21)


Are loans restructured in a TDR always considered animpaired loan which must be accounted for under FAS114?• Yes, these loans stay in the individually evaluated for

impairment bucket permanently– No FAS 5 allowance permitted, impairment

measured under FAS 114• Discussed by FASB Board on January 30, 2008

– Some FASB Board members indicated that it maybe permissible to group loans under a FAS 114approach (ASC 310-10-35-21)

slide 23

Troubled debt restructuringsPractice issues, continuedRequired disclosures for impaired loans• For each balance sheet (ASC 310-10-50-15(a))

– The amount of recorded investment in impaired loans for which there is• A related allowance for credit losses determined in accordance with

ASC 310-10-35 (FAS 114) and the amount of that allowance• No related allowance for credit losses determined in accordance with

ASC 310-10-35– Total unpaid balance of impaired loans

• For each income statement (ASC 310-10-50-15(c))– Average recorded investment in the impaired loans– Amount of interest income recognized during the time within that period that

the loans were impaired– Amount of interest income recognized using a cash-basis method of

accounting during the time within that period that the loans were impaired (ifpracticable).


Required disclosures for impaired loans• For each balance sheet (ASC 310-10-50-15(a))

– The amount of recorded investment in impaired loans for which there is• A related allowance for credit losses determined in accordance with

ASC 310-10-35 (FAS 114) and the amount of that allowance• No related allowance for credit losses determined in accordance with

ASC 310-10-35– Total unpaid balance of impaired loans

• For each income statement (ASC 310-10-50-15(c))– Average recorded investment in the impaired loans– Amount of interest income recognized during the time within that period that

the loans were impaired– Amount of interest income recognized using a cash-basis method of

accounting during the time within that period that the loans were impaired (ifpracticable).

slide 24

Troubled debt restructuringsPractice issues, continuedCan I stop disclosing a TDR as an impaired loan?• Yes – in limited and rare circumstances the disclosures on

the previous slide need not be included in years after therestructuring

• Must meet both of the following conditions (ASC 310-40-50-2)– The restructuring agreement specifies an interest rate

equal to or greater than the rate that the creditor waswilling to accept at the time of the restructuring for anew loan with comparable risk

– The loan is not impaired based on the terms specifiedby the restructuring agreement.


Can I stop disclosing a TDR as an impaired loan?• Yes – in limited and rare circumstances the disclosures on

the previous slide need not be included in years after therestructuring

• Must meet both of the following conditions (ASC 310-40-50-2)– The restructuring agreement specifies an interest rate

equal to or greater than the rate that the creditor waswilling to accept at the time of the restructuring for anew loan with comparable risk

– The loan is not impaired based on the terms specifiedby the restructuring agreement.

slide 25

Troubled debt restructuringsPractice issues, continued

Should the change in the impairment measurementfrom FAS 5 to FAS 114 for a TDR result in adecrease in the ALLL?Considerations• The modification has not changed the fact that the

borrower is experiencing financial difficulty• Should reflect that uncertainty about the timing and

amount of cash flows of a TDR• Impairment measured based on the original loan terms,

not the modified loan• Was there a potential charge-off at time of restructuring?


Should the change in the impairment measurementfrom FAS 5 to FAS 114 for a TDR result in adecrease in the ALLL?Considerations• The modification has not changed the fact that the

borrower is experiencing financial difficulty• Should reflect that uncertainty about the timing and

amount of cash flows of a TDR• Impairment measured based on the original loan terms,

not the modified loan• Was there a potential charge-off at time of restructuring?

slide 26

Allowance for loan and lease lossesResources• Joint Interagency Letter to Financial Institutions (1999)• Interagency Policy Statement on Allowance for Loan and Lease Losses

Methodologies and Documentation for Banks and Savings Institutions(2001)

• SEC SAB 102 – Selected Loan Loss Allowance MethodologyDocumentation Issues (2001)

• Interagency Policy Statement on the Allowance for Loan and LeaseLosses, including the related question and answers (2006)

• Interagency Supervisory Guidance on Allowance for Loan and LeaseLosses Estimation Practices for Loans and Lines of Credit Secured byJunior Liens on 1-4 Family Residential Properties (2012)

• OCC Bank Accounting Advisory Series (BAAS) (June 2012)• FDIC call report instructions


• Joint Interagency Letter to Financial Institutions (1999)• Interagency Policy Statement on Allowance for Loan and Lease Losses

Methodologies and Documentation for Banks and Savings Institutions(2001)

• SEC SAB 102 – Selected Loan Loss Allowance MethodologyDocumentation Issues (2001)

• Interagency Policy Statement on the Allowance for Loan and LeaseLosses, including the related question and answers (2006)

• Interagency Supervisory Guidance on Allowance for Loan and LeaseLosses Estimation Practices for Loans and Lines of Credit Secured byJunior Liens on 1-4 Family Residential Properties (2012)

• OCC Bank Accounting Advisory Series (BAAS) (June 2012)• FDIC call report instructions

slide 27

Allowance for loan and lease lossesResources, continued• Troubled Debt Restructurings: Supervisory Guidance on

Accounting and Reporting Requirements (OCC 2012)• SEC September 2012 Slide Presentation: Update from the

Division of Corporation Finance, 2012 AICPA NationalConference on Banks & Savings Institutions

• SEC CF Disclosure Guidance Topic No. 5: Staff ObservationsRegarding Disclosures of Smaller Financial Institutions

• Federal Reserve Bank -http://www.communitybankingconnections.org

• http://www.fdic.gov/bank/analytical/banking• http://www.occ.gov/topics/credit/index-credit.html• Grant Thornton whitepapers

– Adjustment factors– Loss discovery periods


• Troubled Debt Restructurings: Supervisory Guidance onAccounting and Reporting Requirements (OCC 2012)

• SEC September 2012 Slide Presentation: Update from theDivision of Corporation Finance, 2012 AICPA NationalConference on Banks & Savings Institutions

• SEC CF Disclosure Guidance Topic No. 5: Staff ObservationsRegarding Disclosures of Smaller Financial Institutions

• Federal Reserve Bank -http://www.communitybankingconnections.org

• http://www.fdic.gov/bank/analytical/banking• http://www.occ.gov/topics/credit/index-credit.html• Grant Thornton whitepapers

– Adjustment factors– Loss discovery periods

slide 28

Questions


slide 29

Documents

Allowance for Loan and Lease Losses - FMS Inc for loan and lease losses Simplified view of the FAS 5 allowance computation FAS 5 Reserve [ Loan Category Balance ] Historical Charge