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SRC Insights: Fourth Quarter 2010

Qualitative Factors and the Allowance for Loan and Lease Losses in Community Banks

This is the first of two articles associated with the analysis of the Allowance for the Allowance for Loan and Lease Losses (ALLL). This article discusses improving the analysis of qualitative factors under ASC 450-20 (formerly FAS 5). Based on a variety of observations made by examiners, this article identifies some areas of weakness and also discusses suggested measures and “best practices” outlined within regulatory guidance to help financial institutions further develop their methodologies. During early 2011, we will expand our discussion of the ALLL to include a refresher on impairment analysis and the ASC 310-10-35 Accounting by Creditors for Impairment of a Loan portion of the ALLL (formerly FAS 114).

Current regulatory guidance under SR 01-17, Interagency Policy Statement on the Allowance for Loan and Leases (the guidance), requires that the ALLL methodology must estimate credit losses on groups of loans with similar risk characteristics (homogeneous pools) in accordance with Generally Accepted Accounting Principles (GAAP) under ASC 450-20, Accounting for Contingencies. This is accomplished through the use of qualitative, or “environmental,” factors.

Environmental factors are used to reflect changes in the collectability of the portfolio not captured by the historical loss data. These factors augment actual loss experience and help to estimate the probability of loss with in a loan portfolio based upon emerging or inherent risk trends.

Mechanically, the process typically begins with an institution identifying and applying historical net charge-off rates to homogeneous loan pools based upon actual experience. This is the base point on which an institution then applies environmental factors that would likely cause estimated losses to be different from the historical loss experience. This is normally applied as an “adjustment” to the historical loss rate pursuant to the requirements outlined in the Commercial Bank Examination Manual under Section 2070.1, Allowance for Loan and Lease Losses, “Measurement of Estimated Credit Losses.”

This portion of the ALLL methodology can be challenging. Some challenges which have been observed in Portfolio Segmentation, Selection of Specific Environmental Factors are as follows:

Portfolio Segmentation:

  • Portfolio segmentation into “homogeneous” pools is often less granular than needed. This limits the ability to capture the unique behavioral characteristics that vary the degree of inherent risk or increase the likelihood of loss.
  • Materiality is measured by a loan portfolio's contribution to total assets, not its relevance to risk-based capital.

Selection of Specific Environmental Factors:

  • Environmental factors are not well supported and documented.
  • Environmental factors selected to adjust historical loss rates are often limited or are broadly or too narrowly applied.
  • Environmental factors are premised upon highly intuitive, subjective “opinion”-based factors or limited strictly to suggested guidance examples.
  • The same environmental factors are applied across all portfolio sectors regardless of their specific influence (or lack thereof) on the portfolio.
  • Documentation supporting the relevancy of each environmental factor is sometimes weak.
  • Concentrations are applied only for the commercial real estate (CRE) sector (because it is the subject of the guidance under SR 07-01, Interagency Guidance on Concentrations in Commercial Real Estate).

Assigning Quantitative Values

  • Support for values is not documented or based upon comprehensive analysis. Values used to make the adjustment to historical losses are often not well correlated to the “risk.”
  • Factors are aggregated, and a single flat environmental factor value is applied across all loan pools. Values for environmental factors may not vary based upon the unique risks inherent to each loan pool.
  • “Caps,” or limits, on values assigned to factors are sometimes applied based upon risk severity (low, medium, high) that does not allow for rising trends over time, i.e., risk continues to increase, but the assigned value has been maximized and cannot be increased due to the “cap.”
  • Values for qualitative factors are assigned and then weighted, imposing an additional “cap.”
  • Use of “negative values” and values for one loan pool are netted off of values for factors affecting another pool.
  • Assume that the sum of all qualitative factors must equal 100 percent or 1.

Portfolio Segmentation

Lack of adequate portfolio segmentation, over-use of subjective and unsupported variables, and a lack of understanding of unique inherent risk characteristics within various loan pools may lead to an underfunded ALLL. Therefore, institutions seeking a more thoughtful evaluation of estimated losses should consider the following when developing a comprehensive ALLL methodology.

Portfolio segmentation is one of the key elements to a sufficient ALLL methodology under the regulatory guidance. Under the guidance, “management should segment the loan portfolio by identifying risk characteristics that are common to groups of loans.” In general, many Third District state member banks segment their portfolios into very broad categories, which typically mirror major segments highlighted within the call report.

Broad grouping of loan types may be appropriate for some institutions depending upon the breadth (or lack) of product offerings. However, for institutions with extensive lending capabilities, this approach may obscure underlying risk behaviors that are driving risk within the loan portfolio. These behaviors can become diluted when aggregation occurs. The extent of additional segmentation depends on the size of the institution and the nature, scope, and risk of its lending activities (e.g., new products, significant changes to underwriting, origination in new markets, etc.). In general, the more highly developed an institution's management information systems (MIS) and data mining capabilities, the more accurately risk identification will be for ALLL purposes.

For example, institutions may want to consider other loan pools, such as:

  • Loans in certain poorly-performing markets or geographies where a concentration exists
  • Subordinate loan positions (i.e., junior lien positions for commercial portfolios, etc.)
  • Unsecured loans
  • Open-ended construction loans
  • Asset-based loans (ABLs)
  • Bridge loans or swing loans
  • Unpermitted and not yet zoning-approved land and development loans (dirt loans)
  • Mezzanine loans
  • Agricultural loans
  • Non-recourse loans
  • Floor-plan loans
  • Out-of-market loans
  • Purchased loan participations
  • Loans underwritten during a certain time period (where weak or lax practices may have existed)
  • Home equity loans
  • Loans where repayment/collateral is subject to completion risk

Suggested Environmental Factors

The guidance provides several examples of fundamental environmental factors that an institution should consider, as represented below. Presented as an expanded reinforcement of the guidance, Exhibit I suggests other common risk or loss drivers that could be considered when evaluating inherent risk that may drive losses in a loan portfolio. Best practice would be to prepare an institution-specific and customized risk assessment of each portfolio sector based upon the unique characteristics and loss drivers of that loan portfolio. One example would be to evaluate the underlying causes of loss each time a loss is recorded and maintain that intelligence for ongoing monitoring and review. Migration analysis for certain sectors, portfolios, pools, etc. may also help to identify issues sooner rather than later. This information could be analyzed to determine whether it justifies an adjustment to historical loss rates for ALLL purposes.

(Exhibit I)

Lending Policies and Procedures
  • Changes in lending policies and procedures
  • Changes in underwriting standards and collection
  • Charge-off and recovery practices
  • Increased speculative lending
  • Increased lending in high-risk products or markets
  • Origination of loans with marginal debt coverage ratios (DCRs)
  • High loan-to-value (LTV) ratios
  • Increased granting of unsecured lending
  • Subprime lending
  • Preponderance of loans approved with exceptions
  • Loans to high-risk industries not normally permitted by policy
  • High degree of loan documentation waivers, deficiencies, or an abundance of matured loans (refinance risk)
  • Financial statement exceptions or originations without them
Business Conditions
  • Economic factors (national, local behavior, or both, if applicable)
  • Should consider a variety of drivers, such as inflation, consumer price index (CPI), interest rate environment, housing starts, bankruptcy rates, producer price index (PPI), etc.
  • Should reflect distinctions among geographies (material)
  • Industry/Sector trends (manufacturing, investment real estate, hospitality, etc.)
  • Regional business closings
Loan Profiles and Volume
  • Use supportable proxies for new loan products for which actual historical loss experience or risk profiles are not available
  • Consider infrastructure issues with rapidly-growing portfolios
  • Consider effect of newly-introduced innovative product types with little risk behavior history causing risk in the “unknown”
  • Premiums should be incorporated for high-volume, high-risk areas vs. “bread-and-butter” lending
  • High level of participation risk (one step removed or “agent” risk)
  • Impact of loans subject to maturity or refinance risk
Lending Staff
  • Economics on turnover rates and loss of expertise
  • Absence of qualified staff for workout activities
  • Training issues
  • General lending experience and experience in assigned lending sector
  • Length of employment with the organization
Problem Loan Trends
  • Volume and severity of past due, adversely-classified, or criticized loans
  • Foreclosure rates
  • Level of troubled debt restructurings and modifications
Loan Review Quality
  • Depth and breadth of scope and penetration. Problem loans included? Loss passes review? Selective sample of passes? All portfolios? All lenders?
  • Changes in scoping
  • Quality
  • Experience of team
  • Staffing levels
  • Degree to which staff detects documentation deficiencies and exceptions
  • Findings on consistency or inconsistency in assignment of risk ratings
  • Lack of collateral/unsecured status
  • Type of collateral (trade assets, intangibles, etc.) or lack thereof
  • Declining valuation environment
  • Trend of other factors that affect collateral protection (occupancy, environmental considerations, rent rate declines, number of loans with outstanding taxes — inability to track taxes, documentation deficiencies and unperfected interests, poor collateral administration program, etc.)
Credit Concentrations
  • Not just limited to commercial real estate
  • Measured by the impact to capital, not as a percentage of total assets
  • Diverse analysis—loan types, borrower concentrations, geographic emphasis, sector emphasis, etc.
Competition, Law, and Regulation
  • Impact from ratings agencies
  • Impact of public enforcement actions
  • General regulatory environment from agency oversight
  • Regulatory environment on certain loan sectors (new environmental laws, healthcare reform, etc.)
  • Degree of risk-taking prompted by competitive pressure
  • Participation risk — participant squabbles, legal action, etc.

Environmental Factors and Values

No matter what factors management chooses to emphasize in the ALLL analysis, management must support the actual values for environmental factors that affect historical loss rates. Management must account for and document its inputs for determining these values and must have policies and procedures for executing a change in these values.

To illustrate how broadly institutions are assigning values for qualitative factors, the authors reviewed a number of ALLL methodologies for Third District Institutions. No reviewed institution expanded qualitative factors outside those highlighted in the guidance. In addition, some determined that some factors did not even apply, even though, for items such as concentrations, the organization actually had high exposure risk in certain concentrated sectors.

Certainly, management must ensure that assigned values for estimated loss are appropriate, and that the cause and effect of these drivers can be tracked over time and changed depending upon circumstances and trends. If the process is too random, subjective or if the changes in values do not keep pace with the impact of increased risk, then institutions will find the ALLL to be inadequate and potentially directionally inconsistent. This can result in regulatory criticism as well and may ultimately result in supervisory requirements for increased capital levels, potential limitations on dividends, or other enforcement actions to ensure the safety and soundness of an institution.

Recent Accounting Developments

At the time of the writing of this article, the Financial Accounting Standards Board (FASB) has proposed amendments to disclosures under ASC 450. The proposed amendments seek to broaden financial statement reporting regarding the types of contingencies required to be disclosed. In addition, the proposed amendments increase qualitative and quantitative descriptions of those contingencies within the notes of the financial statements, specifically surrounding loss contingencies related to litigation proceedings. While the possibility exists that this proposal may enhance the disclosures related to qualitative factors, the current version under consideration does not appear to have a material impact on financial accounting and reporting of estimated loan and lease losses and related disclosures.


In summary, development of well-supported and appropriate environmental factors for homogenous loan pools when determining the ALLL requires 1) meaningful and thoughtful consideration of all of the environmental factors to which a particular portfolio is currently vulnerable, 2) the ability to segment the loan portfolio into pools that behave similarly under certain economic conditions, 3) the development of supportable values for all environmental factors, and 4) the ability to fully understand the fundamental behaviors and underlying risk of each portfolio sector.

If you would like additional information or have questions about ASC 450-20 and the ALLL, please contact Sharon D. Wells ( at (215) 574-2548 or Trevor Gaskins ( at (215) 574-6093. Third District institutions are also encouraged to contact their assigned portfolio manager with related institution-specific questions or concerns as they pertain to this subject matter.

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.