Since bank examiners pay special attention to the allowance for loan and lease losses (ALLL) as part of a regulatory examination, it doesn’t pay for community banks’ management to stick their heads in the sand. Why? The consequences of a bank’s ALLL being underfunded can be steep and may include:
- Downgrading the bank’s CAMEL rating.
- Requiring increased capital levels.
- Taking other remedial action.
So what are the two the most common mistakes community banks typically make when calculating ALLL?
Common ALLL Community Bank Mistake #1: Qualitative Factors
In 2006, federal banking agencies published an Interagency Policy Statement on the ALLL stating that the starting point in its measurement should be to “determine the historical loss rate for each group of loans with similar risk characteristics in its portfolio.”
Community banks too often limit this analysis to broad factors outlined in the policy statement without incorporating bank-specific risk assessments for each portfolio segment.
The often-overlooked second factor of the measurement requires banks to evaluate qualitative factors likely to cause the bank’s estimated credit losses to vary from historical losses. When not overlooked, banks typically have issues gauging the impact of qualitative, or “environmental,” factors that cause the bank’s loss estimates to deviate from historical loss experience.
The qualitative factors often include changes in:
- Bank lending policies and procedures.
- Loan volume, terms, or profiles.
- Lending staff’s experience.
- The volume or severity of problem loans.
- Loan review quality.
- Collateral values.
- Credit concentration levels.
Banks also should consider other external factors, including competition, international to local business conditions, and legal and regulatory requirements. Finally, bank management’s evaluation of qualitative factors affecting the ALLL should be documented and objective.
Common ALLL Community Bank Mistake #2: Inadequate Loan Portfolio Segmentation
Another common weakness in banks’ typical methodologies is inadequate portfolio segmentation. The Interagency Policy Statement instructs banks to group loans with similar risk characteristics, but many banks only segment their loan portfolios into overly broad categories that may not accurately reflect underlying risk factors. Depending on a bank’s size — and the nature and scope of its lending activities — it may be appropriate to segment the loan portfolio into narrower categories.
Next Steps for Improving Your Community Bank’s ALLL Methodology
To ensure that your bank’s ALLL is adequately funded, review your methodology and ensure that your community bank is incorporating documented qualitative factors. Also, consider the depth of your community bank’s loan portfolio segmentation and ensure that it’s been adequately segmented to serve its purpose of helping identify underlying risk factors.
CRI’s community bank CPAs and business advisors can help you design ALLL policies and procedures that accurately reflect your bank’s unique risk profile. Leverage CRI’s banking expertise and your community bank will be ready to face bank examiners and ALLL reviews.