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What are other banks doing with the ALLL?

November 5, 2014
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During a recent webinar, more than 200 banks and credit unions weighed in through various polls on how they have been managing their allowance for loan and lease losses. In particular, feedback was given on how they release reserves, use an unallocated reserve and use external Q factor(s) most heavily.

The first topic of discussion was whether or not banks have released reserves in the past four quarters. From an outside perspective, it may seem that financial institutions can and should release reserves to reflect the improving economic conditions of the past year. If a bank’s reserve is already “padded” and we see both economic and credit quality indicators improve, then it makes sense that the amount the bank sets aside for bad debts should decline slightly.  Risk is lower, so banks would need a smaller reserve.

However, despite improvements in the economy and credit quality, most banks participating in the poll, roughly 70 percent of respondents, indicated they have not released reserves in the last four quarters. Many factors are at play which might have discouraged the release of reserves: 

concerns about the stability or sustainability of recent economic improvement, 

fear of having to borrow back from shareholders if credit quality worsens, 

regulatory uncertainty about the CECL model’s impact on the ALLL, 

aversion to risk and allowance changes (i.e., “We have a healthy reserve, and we operate just fine, so why release any of it?”)

A related topic of discussion was the use of an unallocated reserve. While the presence of an unallocated reserve can raise examiner eyebrows given it falls outside the nine qualitative factors as outlined by Interagency Guidance, many institutions, according to the poll, have used an unallocated reserve in the last year. Sixty percent of bankers who responded to the poll indicated they had used this strategy.

Lastly, and since the theme of the webinar was “How to justify qualitative factors in periods of low loss,” bankers indicated which external qualitative factor received the most weight. Of the four options, “Value of underlying collateral for collateral-dependent loans” was the most significant Q Factor for almost 40 percent of responses. A more detailed breakdown of responses is highlighted below:

 

Also worth noting is that a significant amount, 17 percent, of respondents mentioned they relied most heavily on “other” qualitative factors that fell outside of the nine recommended in 2006 Interagency Guidance

So what does this mean? Financial institutions are going out of their way to keep reserves at fairly conservative levels. Despite an improving economy, less than a third had released reserves in the past four quarters. Moreover, financial institutions have been going above and beyond the typical qualitative factors (which are meant to adjust the quantitative ALLL calculation to accurately reflect expected credit losses) and have been using unallocated reserves and other qualitative adjustments to maintain their ALLL at fairly high levels. 

Whether this derives from uncertainty in the future of the economy and legislation, or if this trend is a manifestation of more conservative banking practices following one of the worst financial crises we’ve ever seen is up for discussion, and likely the answer falls somewhere in between. The fact of the matter remains, however, that banks, despite improving economic conditions, are hesitant to release reserves. 

To learn more about other bankers’ opinions on a range of topics surrounding the ALLL, download our whitepaper, 13 ALLL Questions. It is a compilation of responses to similar polls about processes, challenges, and thoughts on several components of the ALLL calculation.

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