Western Independent Banker - July/August 2008 - (Page 22)

By Jeremy D. Taylor with Len Filppu How to Fine-Tune ALLL During Uncertain Times IN THE CURRENT economic climate of weakening real estate prices, rising jobs losses, and recessionary warnings, bank management must be vigilant about the potential for rapid deterioration in credit quality – and to the adequacy and justifiability of their Allowance for Loan and Lease Losses (ALLL). The methodology for loss reserving must be prudent, proactive and able to pass increased regulatory scrutiny, while keeping the bank ahead of gathering storm clouds. This isn’t easy in the best of times. The challenge now comes from boosting reserves according to what instinct, common sense and experience all say is necessary, even as standard credit measures like past-due, criticized and migration trends have yet to manifest the full impact of growing pressures on borrowers. Before delving into some of the specifics of how regulators expect the ALLL methodology to be constructed and maintained, a more fundamental point must be made. The underlying foundation for the ALLL calculation (as it is for loan pricing, credit risk capital requirements and other applications) is the bank’s risk grading (RG) system. The validity of the ALLL calculation hinges on the reliability and integrity of the RG assigned to individually-graded loans (such as Commercial & Industrial, Commercial Real Estate, Construction). This means not just a careful process of analysis and review at the inception of a loan, but also procedures to ensure that the grade is subsequently adjusted quickly and accurately in the event that creditworthiness changes over time. To the extent that downgrades are resisted, the reserve calculation will be understated. Here are points to reinforce the importance and efficiency of the RG system: • Sufficient granularity to ensure meaningful differentiation in credit quality. Many banks will have upwards of 50 percent of their graded portfolio in only one RG bucket. More grades, carefully applied, can help better identify where management attention is needed, where higher pricing may be called for, and where the ALLL amount should be increased. • Credit policy that provides clear guidance on assigning RG to a loan – and on adjusting it as required. That guidance could usefully include indicative financial ratios by major loan category. • Appropriate separation of duties, including that between the underwriting of a loan and the credit administrator approving it. • An independent and experienced loan review function to offset the inertia in assigned grades that a prolonged period of benign credit conditions can produce. • And, as in so many other respects, an active role for senior management and the board in promoting an appropriate control environment – one that fosters RG integrity. What about the ALLL set-up itself? The December 2006 Interagency Guidance on the ALLL provides a roadmap for enhancing a bank’s approach, though it’s only a rough map requiring considerable interpretation and supporting analysis. Start with specific vs. general reserves. Impaired loans require specific (i.e., individualized) reserving per SFAS 114. The bank itself defi nes impairment (nonaccrual, for example) and then a reserve amount for each such loan is calculated. There are three ways it can be calculated, the most important of which is the discounted value of the principal and/or interest cash flows realistically expected period by period. The general reserve is guided by SFAS 5. Unallocated reserves can be used, but not over-used. Rather, divide up the nonimpaired loans by RG and by type of loan – and perhaps by other characteristics as well, for larger, more complex portfolios. Then allocate reserves to each segment (for example: RG 5 Construction loans) by applying an appropriate loss factor to that segment’s balances. The loss factors ideally reflect the bank’s own experience. Otherwise, pull peer data (e.g., from the FDIC’s Web site) to help establish reasonableness. What the regulators then want to see is a process whereby the prior quarter’s matrix of loss factors is modified based on the set of eight “Qualitative and Environmental Factors” identified in the Guidance statement, each of them expressed in terms of change from prior quarter-end. The trick, of course, is quantifying what are innately subjective considerations. Rate them, weight them, and then mix in a good dose of common sense. Regulators are placing the greatest emphasis on collecting and integrating internal loss data as diligently as possible; segmenting the portfolio into reasonably homogeneous buckets of risk; conducting an annual, independent validation of the ALLL methodology; and, to fi nish up where we began, ensuring that risk grades swift ly and effectively capture changes in credit quality. Th is should make quarterover-quarter swings in the ALLL less dramatic and more transparent. Jeremy D. Taylor is director of client services for AuditOne, LLC, a California-based risk management services firm. He can be reached in AuditOne’s Southern California office at (562) 802-3581 or at jeremy.taylor@ audit-one.com. Len Filppu is AuditOne’s director of marketing communications. He can be reached in AuditOne’s Northern California office at (408) 980-8099. Before delving into some of the specifics of how regulators expect the ALLL methodology to be constructed and maintained, a more fundamental point must be made. The underlying foundation for the ALLL calculation is the bank’s risk grading system. 22 www.wib.org Western Independent Banker http://www.wib.org

Table of Contents Feed for the Digital Edition of Western Independent Banker - July/August 2008

Western Independent Banker - July/August 2008 Contents A Message from the President & CEO Getting Creative and Competitive with Leaders' Incentive Compensation Financial Covenants - What Good Are They Really? Homes Within Reach Revisiting Credit Quality and Risk Management Loan Yield Shock Wave - What Can You Do? What Lending Crisis? - Community Banks Flex with Lending Strength How to Fine-Tune ALLL During Uncertain Times Productivity, Technology and Export Growth Trump Housing's Fall in the Long Run - The Economy According to Brian Wesbury Distressed Real Estate Loans and Their Property Tax "Kicker" WIB Calendar Welcome New Members Index to Advertisers advertiser.com

Western Independent Banker - July/August 2008

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