Loan Loss Reserves

For a summary of how accounting for loan loss reserves fits into the FASB's and IASB's projects on financial instruments, click here.

Issue

Within the provisions of Generally Accepted Accounting Principles (GAAP) accounting and the asset classification standards of the federal bank regulatory agencies, depository institutions and their holding companies must establish and maintain adequate allowances for loan and lease losses (ALLL).

General Position Statement

The process of establishing an appropriate loan loss reserve involves a significant amount of discretion and expert credit judgment.  It must take into account not only a bank's historical experience, but also current economic conditions, and the intimate knowledge a bank has with its customers. ABA supports the process of applying regulatory guidance to loan loss reserves. However, ABA opposes any effort to move toward an accounting approach that restricts bank management's ability to utilize its expertise when determining loan loss reserve levels.  As a result of management's judgment, additional reserves may be recorded that are not necessarily identified through empirical analysis.

Underlying the above concepts is that any method to measure loan loss reserves must be operational – the benefits of the process must clearly outweigh the costs of measurement impairment within demanding quarter-end closing timer periods.  Second, the results must be conceptually understandable by all stakeholders, including management, regulators, and investors.  Finally, the process must be understood to be centered in judgment of different parties (management and real estate appraisers are examples) that is based on a point in time and judgments can change very rapidly.

To see the ABA Comment Letter to the IASB on their 2009 Request for Information on Impairment of Financial Assets: Cash Flow Approach, click here.

Upcoming Changes to the Measurement of Loan Loss Reserves

The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have issued separate proposals on loan loss reserves to measure the amount of reserves required.  The IASB has issued an exposure draft that proposes loan loss reserves to be measured so that the net amortized cost of the related loan (after the loss reserve) equal the present value of future cash flows over the life of the loan (based on the original effective interest rate, not a current interest).  Such present values will include estimated prepayments and equates to a process similar to that used to estimate reserves for impaired loans under SOP 03-3 in the U.S.  The IASB impairment model is, in substance, an expected cash flow model.

The FASB is expected to issue an exposure draft which merely eliminates the current "triggers" that denote when a loss is "probable" that it has been "incurred".  FASB, in other words, requires an estimate, based on current facts and circumstances, of expected losses.  It appears that the FASB estimate may not take into account future changes in the economic climate.  Therefore, economic balloons or troughs may not be forecast to change.  Some equate this as an "enhanced incurred loss" approach.

In both cases, the difference between the price of the loan and the expected net yield is embedded as an adjustment to the effective yield, as opposed to recording a full loss reserve at issuance.

ABA has not fully examined each approach in light of the position statement above.  It appears, at first glance, that, based on bankers' experience with SOP 03-3, the IASB model is extremely difficult operationally.  The FASB model does appear to be operationally simpler.  An immediate question under both proposals is what kinds of audit evidence will be required by independent auditors and examiners.

Disclosures

Expansion of ALLL disclosures is in store for both the IASB and FASB proposals.  Key changes under IASB include:

• Stress testing disclosures, if available from internal risk management reporting,
• Comparison of the development of the credit loss allowance over time with cumulative write-offs,
• Disclosures of non-performing assets and reconciliation to changes in the ALLL account, and
• Vintage of loans (origination and maturity by year).

FASB has not indicated any further changes under its upcoming impairment proposal.  However, FASB is expected to shortly issue a separate final accounting standards update specifically on enhanced disclosures of credit loss reserves.  This update is expected to include:

• Roll forwards of the ALLL balance by portfolio
• Credit quality indicators by portfolio (using credit ratings or internal scores)
• Default aging of the portfolio
• Carrying amounts of specifically-identified impaired loans
• Amounts regarding nonaccrual loans
• Amounts regarding charge-offs
• Certain details regarding loan modifications and troubled debt restructurings.

Based on, among other things, ABA's comment letter to eliminate requirements initially proposed by the FASB that included fair value detail, SOP 03-3 detail, and a roll forward of the receivables balance, ABA believes that each of these remaining items are useful, but the information must reflect the risks at each specific entity.  Care also must be taken in order to not divulge specific confidential company-based data.

ALLL Regulatory Guidance Links

• Comptroller of the Currency Comptroller's Handbook "Allowance for Loan and Lease Losses"(1998)
• Comptroller of the Currency Bank Accounting Advisory Series (December 2008)
• Policy Statement on Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions (July 2001)
  This policy statement outlines the standards for documentation of the ALLL process and methodologies under FAS 114 and FAS 5.  It also includes standards for summarizing and validating the methodologies.
• Interagency Policy Statement on the Allowance for Loan and Lease Losses (December 2006)
  This policy statement outlines responsibilities of the Board of Directors and management regarding the ALLL, including factors to consider in determining the ALLL under FAS 5 and FAS 114 and how loan review systems and loan classification systems should be designed.
• OTS Memorandum for Chief Executive Officers: ALLL - Observed Thrift Practices Including Sound Practices
• Center for Audit Quality White Paper: Application Of Statement 114 To Modifications Of Residential Mortgage Loans That Qualify As Troubled Debt Restructurings (December 2008)
• Interagency Policy Statement on Prudent Commercial Real Estate Workouts (October 2009)
• SEC "Dear CFO" letter sent to public companies MD&A Disclosure Regarding Provisions and Allowances for Loan Losses.