ALLL Back to Basics
With all of the talk about CECL, sometimes you just need to go back to the allowance basics. Chris Emery, MST’s Director of Special Projects, is the ‘professor’ on the ALLL. Since 2004, Chris has been dedicated to the development of advanced technology solutions related to the ALLL. He has worked with institutions of all sizes and characteristics throughout the U.S. to automate and streamline their ALLL methodologies, and presents regularly through webinars and at conferences. Watch this MST Talk video with Chris Emery on ALLL Back to Basics.
What is the ALLL?
An appropriate ALLL covers estimated credit losses on individually evaluated loans that are determined to be impaired as well as estimated credit losses inherent in the remainder of the loan and lease portfolio. “Estimated credit losses” means an estimate of the current amount of loans that it is probable the institution will be unable to collect given facts and circumstances as of the evaluation date. (2006 Interagency Policy Statement on the ALLL).
Components of the ALLL include:
- Loans Collectively Evaluated for Impairment (ASC 450-20 f/k/a FAS 5)
- Loans Individually Evaluated for Impairment (ASC 310-10 f/k/a FAS 114)
- Purchased Credit-Impaired Loans (ASC 310-30 f/k/a SOP 03-3)
- Unallocated Reserves
Under current GAAP, incurred losses are losses that are probable to have occurred, but have not yet been confirmed. Under CECL, expected losses are losses that are expected over the remaining lives of the loans.
Loans Individually Evaluated for Impairment (ASC 310-10)
An individual loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. It is implicit in these conditions that it must be probable that one or more future events will occur confirming the fact of the loss. (2006 Interagency Policy Statement on the ALLL)
Methods for measuring impairment are:
- Present Value of Future Cash Flows
- Fair Value of Collateral
- Observable Market Price of the Loan
Loans Collectively Evaluated for Impairment (ASC 450-20)
- Loans not determined to be already impaired.
- Loans segmented into groups (“pools”) with similar risk characteristics.
- Once segmented, pools become the basis for estimating incurred losses based on past events (quantitative) and current conditions (qualitative).
Estimated losses may represent a single large loss within the pool, or many smaller losses.
ASC 450-20 – Quantitative and Qualitative
Normally, an institution should determine the historical loss rate for each group of loans with similar risk characteristics in its portfolio based on its own loss experience for loans in that group. While historical loss experience provides a reasonable starting point for the institution’s analysis, historical losses, or even recent trends in losses, do not by themselves form a sufficient basis to determine the appropriate level for the ALLL. (2006 Interagency Policy Statement on the ALLL)
Many institutions choose to average the aggregate net charge-offs (charge-offs-recoveries) on an annual or quarterly basis over a defined period of time (the lookback period) and then divide this total by the average balance over the same period. If this is done using quarter-by-quarter balances, the final result should be multiplied by four to produce an “annualized” loss rate.
Loss Emergence Period: The time between the incurred loss event and the confirmation of the loss.
- Should reflect the best estimate of the average distance between incurred loss events and confirmation of losses.
- May (and probably should) vary between different loan pools or segments.
Cohort or Migration Analysis
- Tracking groups of loans based on a particular criteria (“cohorts”) over a series of periods and then analyzing the eventual net losses associated with that group of loans.
- This establishes a loss rate which can then be applied to loans matching those same criteria going forward.
While historical loss experience provides a reasonable starting point for the institution’s analysis, historical losses, or even recent trends in losses, do not by themselves form a sufficient basis to determine the appropriate level for the ALLL. Management should also consider those qualitative or environmental factors that are likely to cause estimated credit losses associated with the institution’s existing portfolio to differ from historical loss experience. (2006 Interagency Policy Statement on the ALLL)
Watch this MST Talk video with Chris Emery on ALLL Back to Basics.