Why do banks maintain an unallocated reserve?
The unallocated reserve can play an important role in maintaining a financial institution’s overall reserve; however, it is, by nature, a rather subjective process. Unallocated reserves are the result of an adjustment to account for estimated credit losses which fall outside of the predefined qualitative factors and historic loss calculations.
Unallocated reserves are necessary when an institution applies qualitative risk factors and historic loss calculations to the reserve, yet still expects credit losses as of the evaluation date to exceed that of the reserve (above and beyond the qualitative factors adjustment). Because qualitative factors are meant to quell any disparities between the reserve amount and the estimated credit loss amount as calculated by management, it is imperative that institutions document and justify exactly why they are making any provisions to the unallocated reserve. That is, they must explain why there is an extraneous variable that forces them to bolster the reserve beyond the measures allowed by qualitative factors, and justify that the amount is necessary to satisfy the conditions expected.
Examples that may support an unallocated reserve include:
• Natural disasters
• Drastic uncertainty in the economy
• Internal activity (such as M&A)
• Legislation impacting expected credit losses
Guidance does not specify a maximum for unallocated reserves, but any provision must be thoroughly documented to explain why that unique circumstance merits additional funds to be set aside.
Streamline the reserve calculation process and impress examiners.
The unallocated reserve is inherently met with varying levels of acceptance. On one side, examiners want to see a reserve that reflects an accurate measure of expected credit loss – neither skimped nor overestimated. Banks risk bad exams and bad standing with regulators if their reserve is not representative of current economic conditions and the performance of their portfolios.
On the other side are shareholders. They are aware that a provision to the reserve inversely affects profits, and in turn, dividend value. In a way, any provision to the reserve takes money out of their pockets, so reluctance to release reserves, or a conservative estimation of the reserve by management, is often met with shareholder discontent. Amid the myriads of critical responsibilities of the CFO, arguably the foremost involves generating a reserve calculation which placates shareholders on all ends of the spectrum.
Thus, financial institutions must walk a narrow line to appease the array of stakeholder interest. The best way to ensure that an institution is in compliance with their unallocated reserve (not surprisingly) is to accurately reflect expected credit losses. The qualitative factors adjustment allows a bank to amend the historical loss rate to reflect current conditions. However, in unique circumstances, the unallocated reserve can and should be used to bridge the gap between the post-qualitative factor adjusted reserve and current economic conditions.
To learn more about qualitative factors and ensuring objectivity in calculating your reserve, check out this whitepaper on Qualitative Risk Factors: How to Add Objectivity to an Otherwise Subjective Task.