The Allowance for Loan and Lease Losses (ALLL) calculation can be one of the more complex processes in running an efficient and regulatory compliant financial institution.
Specifically, determining the most appropriate ALLL methodology is a significant challenge institutions face in calculating an adequate allowance.
While regulatory guidance is scarce, latitude is given to each institution to select the valuation methodology best suited for its own unique characteristics and complexities. According to the Office of the Comptroller of the Currency (OCC), multiple methodologies are accepted.
“The OCC does not require that banks use a specific method to determine historical loss experience. The method a bank uses will depend to a large degree upon the capabilities of its information systems. Acceptable methods range from a simple average of the bank’s historical loss experience over a period of years, to more complex migration analysis techniques.” *
Migration analysis is a rigorous analytical process recommended by the regulatory agencies to determine financial institutions’ ALLL; yet it is often underutilized in lieu of other, easier processes. This type of analysis uses loan level attributes to track the movement of loans through the various loan classifications in order to estimate the percentage of losses likely to be incurred in a financial institution’s current portfolio.