The allowance for loan and lease losses (ALLL) is a valuation account estimate for uncollectible loans and leases. Banking organizations use current income, through the provision for loan and lease losses, to fund this account. The ALLL is one of the most significant estimates in a banking organization's financial statements and regulatory reports. Banking organizations are required to develop, maintain, and document a comprehensive, systematic, and consistently applied methodology for estimating the ALLL in accordance with generally accepted accounting principles (GAAP) and supervisory guidance. The downturn in the current credit cycle places additional emphasis on the ALLL in a banking organization's ability to weather changing credit conditions.
For a number of reasons, in recent years banking organizations have consistently been provisioning less for loan and lease losses. Accounting transparency rules, for example, strive to eliminate the practice of including unsupported amounts in the reserve to account for uncertainty and to smooth earnings. While current ALLL guidance permits the practice of including amounts in the allowance that are unallocated, these amounts must reflect an estimate of probable losses, determined in accordance with GAAP, and must be supported properly. Another factor contributing to the trend in lower provisions is the improved risk management models many banking organizations have implemented.
At the same time, earnings pressures resulting from intense competition and challenging yield curve conditions have encouraged banks to look for ways to boost income while keeping expenses low. To support higher income, some banks have adopted a strategy of maintaining lean provisions for loan and lease losses. The financial performance of banks that employed this approach would have benefited during the long stretch of exceptionally sound asset quality from which the industry is now emerging.
In the Third District, the allowance for loan and lease loss coverage of total loans has hovered at historic lows for the past several years, mirroring the national trend. While asset quality remains sound, there is evidence of deterioration, albeit from historically low levels, as nonperforming assets for the nation and the Third District rise. At the national level, for example, nonperforming assets reached .63 percent of total loans and other real estate owned in the second quarter of 2007, the highest level since the third quarter of 2004, but still well below the peak of 3.7 percent in 1990. During this same period, over 80 percent of insured commercial banks increased provisions, and total provisions jumped 25 percent in anticipation of higher loan losses. These data support the view that banking organizations are increasing their provisions in response to worsening credit conditions and the housing downturn.
In comparison, less than half of the commercial banks in the Third District increased provisions in the second quarter of 2007, and the majority of those that did so increased provisions modestly. The remaining banks either decreased or maintained the same level of provisions from the previous quarter. Third District commercial banks also reported a relatively low aggregate net charge-off rate of .17 percent in the second quarter, a marked contrast to loan losses for the industry, which measured .53 percent, up from .48 percent in the first quarter.
These differences may reflect the fact that Third District banks are more insulated from the negative effects of the subprime mortgage crisis or evidence a more conservative lending strategy, or they may suggest more balanced regional economic conditions. This could also signal that some Third District banks may be lagging the industry in acknowledging problem loans or adjusting loss estimates based on current economic and industry conditions. Bank examiners have observed that community bankers, in particular, have been slower in past credit cycles to identify problem loans and recognize losses than larger banks.
As credit conditions deteriorate, however, there is more potential for credit problems to emerge. An appropriate ALLL that is reflective of the current risk exposure in a bank's loan portfolio is especially critical during cyclical downturns when the potential for credit losses is greater and capital becomes more expensive. Bolstering provisions too late in a credit cycle can magnify the impact on a bank's income and capital if loan quality deteriorates more quickly than a bank anticipates.1 Banks with low ALLL coverage of nonperforming loans and leases and rising delinquencies are the most vulnerable.
Examiners evaluate the appropriateness of the ALLL based on an assessment of the credit quality of the loan portfolio, the effectiveness of the bank's loan review function, and a review of other credit-related processes and controls. As examiners assess these areas, they look for red flags that could signal an inappropriate ALLL, such as basing the ALLL on budgeted amounts, target statistics, or ratios without relevant supporting documentation, or applying an overall adjustment to bring the ALLL to a predetermined percentage of loans.
Examiners also consider whether overall adjustments to the ALLL are directionally consistent. For example, if a number of qualitative or environmental factors are changing, such as regional unemployment rates, consumer confidence levels, or housing sector indices, in most cases, examiners would expect to see a corresponding adjustment to the ALLL.
For more information on developing an appropriate ALLL methodology, banking organizations are encouraged to review current supervisory and GAAP guidance. In addition, the Federal Reserve has developed an ALLL job aid for examiners that lists all relevant current guidance and provides other pertinent information, such as common ALLL-related terminology, the steps examiners take when evaluating the ALLL and the methodology, a flow chart of the interaction between FAS 114 (loss estimation for individual impaired loans) and FAS 5 (loss estimation for homogeneous pools of loans), inappropriate loan loss estimation practices, and other relevant information.
While the job aid does not constitute official policy and is not a substitute for management judgment and analysis, banking institutions may find it useful, in particular, to understand how examiners evaluate a bank's ALLL methodology. If you have any ALLL-related questions or would like to obtain a copy of the Federal Reserve's ALLL job aid, please contact Eddy Hsiao (firstname.lastname@example.org) at (215) 574-3772 or William Lenney (email@example.com) at (215) 574-6074.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.