The Quest for a 'Reasonable' Allowance for Loan and Lease Losses

By Steven Wilson

Over the past several years, the emphasis on the level and adequacy of the Allowance for Loan and Lease Losses (ALLL) by bank regulators has increased. After significant dialogue among bankers, regulators, and external accountants, it appears that most institutions are utilizing ASC 450 and ASC 310 in their methodologies. In many cases, however, it’s difficult to determine how much is enough, as the processes for calculating the ALLL are not always producing sufficiently reasonable estimates of loss in today’s economic environment. As the current environment continues to challenge the effectiveness of existing ALLL methodologies, some banks may still need to augment their existing processes.

The December 2006 “Interagency Policy Statement on the Allowance for Loan and Lease Losses” (SR 06-17) calls on the board of directors and management of banks to develop and maintain an appropriate ALLL methodology that is fully documented, auditable, and periodically validated by an independent party. It also requires them to analyze the overall measurement of the ALLL. The guidance acknowledges that determining the appropriate level for the ALLL is inevitably imprecise and requires a high degree of management judgment. In that regard, institutions are encouraged to utilize ratio analysis as a supplemental tool for evaluating the overall reasonableness of reserve levels. When used prudently, ratio analysis can serve as a barometer for the reasonableness of management’s assumptions and analysis and may identify additional factors that might not have been considered in the initial ALLL estimation process.

Two questions are often posed: What do examiners look for when reviewing the ALLL, and what asset-quality indicators are used when assessing the reasonableness of the reserve? The 2006 guidance, in addition to serving as direction for bankers, discusses the responsibilities of examiners, who are charged with assessing the credit quality of an institution’s loan portfolio and the appropriateness of its ALLL methodology and documentation. In conducting this assessment, examiners are encouraged to perform a quantitative analysis as a preliminary check on the reasonableness of the ALLL.

In response to the increased emphasis on the reserve methodology and adequacy of overall ALLL levels, the Federal Reserve System developed an examination workprogram with ASC 450, ASC 310, and the 2006 guidance as its foundation. In addition to the workprogram, a ratio analysis worksheet is prepared for each institution, highlighting current ratio levels, trends, and comparisons with various groups of peer institutions. This worksheet aids in the examiner’s assessment of the reasonableness of the ALLL.

Concern by regulatory agencies has been heightened over the lack of directional consistency between increases in ALLL levels and the overall erosion in portfolio quality indicators. The level of reserves to noncurrent loans peaked during the 2005-2006 time period. However, through the first quarter of 2011, reserves to noncurrents had fallen to less than 25 percent of the peak levels, while the level of noncurrent loans as a percentage of total loans increased more than fivefold (542 percent). Meanwhile, total reserves as a percentage of total loans increased a mere 61 percent. These data challenge directional consistency patterns within the industry.

ALLL Chart

As demonstrated above, a simple ratio analysis can provide the examiner with a clearer picture of the degree of change between the level of the ALLL and the level of any given credit quality metric. With directional consistency, changes in loan loss provisions, the level of the ALLL, and credit quality indicators should not only be directionally consistent, but also proportional. Comparing the level of the ALLL at an institution with a peer group with similar characteristics (e.g., asset size, loan portfolio size, portfolio composition, markets served, etc.) helps the examiner determine if the level is reasonable. Examiners will evaluate whether coverage levels appear sufficient relative to risk characteristics and market conditions. Consideration is also given to the examiners’ assessment of whether the bank is appropriately identifying and recognizing TDRs and nonaccrual loans in a timely manner.

In addition to noncurrent loan metrics, other ratios considered by examiners during the “reasonableness” assessment of the ALLL may include, but are not limited to:

  • ALLL/Nonaccrual
  • ALLL/Net losses (annualized)
  • ALLL/Total classifications
  • ALLL/Total loans

Appropriate ratios are compared to several different peer group averages over successive quarters as part of a trend analysis. Not all ratios are appropriate in all cases. Given the risk profile of the institution, examiners use judgment in determining those ratios that will provide meaningful analysis.

After an initial review is performed on the ALLL levels, the examiner determines if the ALLL is directionally consistent given the trends in the asset quality indicators and if the level of the institution’s ALLL is comparable to that of peer institutions. If disparities are noted, the examiner assesses which characteristics should be further explored and analyzed more thoroughly to determine rationales for disproportionate comparisons. Findings from this pre-examination analysis are considered when reviewing the bank’s ALLL methodology and assessing its adequacy.

If the examiner review of the institution’s procedures indicates that a meaningful and appropriate ALLL methodology is being utilized, and reserve levels appear adequate based on the overall credit/risk indicators, additional review during the examination would likely not be warranted. However, if upon examination the ALLL methodology is determined to be inappropriate or unacceptable, and reserve levels are deemed inadequate, then examiners may alter the bank’s methodology to produce an adjusted reserve using bank-specific information, which may result in required amendments to the bank’s methodology. If this remedy is not adequate to produce a reliable reserve estimate, on rare occasions, examiners may use a short-term proxy. Any short-term proxy must be consistent with the Interagency Guidance, which indicates that such estimates based on industry or peer-group information should only be used as a short-term resolution. Proxy reserve levels are not intended to be a substitute for an effective ALLL methodology, but are only to be used until bank management corrects deficiencies in the institution’s methodology and implements an appropriate and adequate methodology that will result in an appropriate ALLL — normally within one quarter.

Bank management teams continue to spend a lot of time developing and enhancing their ALLL methodology practices, but one of the more under-utilized tools is that of a reasonableness test based on ratio analysis. While ratio analysis is not intended to be a stand-alone basis for determining an appropriate ALLL level, the practice may shed additional light on the effectiveness of existing processes and these additional considerations may warrant further adjustments to estimated credit losses.

So, what is a reasonable level for the ALLL? A reasonable level is one that’s supported by an adequate and appropriate ALLL methodology that is compliant with applicable guidance, is sufficient based on estimated credit losses, and exhibits directional consistency in relation to movements of the institution’s asset-quality indicators.

Steven Wilson is a supervisory examiner with the Federal Reserve Bank of Richmond and can be reached at

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