The Allowance for Loan and Lease Losses (“ALLL”) represents one of the most significant estimates in a financial institution’s financial statements, as the appropriateness of these loss provisions is critical to an institution’s safety and soundness. Consequently, as the banking industry struggles to recover from the most significant economic downturn since the Great Depression, institutions face intensified regulation and scrutiny pertaining to their ALLL calculations. There are several overarching challenges in the estimation of the allowance for loan and lease losses process that financial institutions face with regularly.
Although the ALLL has many components, one stands supreme in difficulty – the determination of appropriate qualitative risk factor adjustments. Lack of specific direction on how these determinations are to be made provides management teams with tremendous leeway in manipulating their ALLL calculations; however, it also exposing institutions to significant regulatory scrutiny. Regulators want structure and consistency in this inherently subjective task, but a modern-day author, Toby Beta, wrote, “Subjectivity measures nothing consistently.”
Management can use the recommendations and suggestions below to help add objectivity and structure to this otherwise subjective task and appropriately justify their assumptions.