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5000 - Statements of Policy
{{12-29-06 p.5453}}
Interagency Policy Statement on the Allowance for Loan and Lease
Losses 1
Purpose
The Office of the Comptroller of the Currency, the Board of
Governors of the Federal Reserve System, the Federal Deposit Insurance
Corporation, and the Office of Thrift Supervision, jointly with the
National Credit Union Administration, have revised the banking
agencies' 1993 policy statement on the allowance for loan and lease
losses (ALLL) to ensure consistency with generally accepted accounting
principles (GAAP) and more recent supervisory guidance. The banking
agencies originally issued the 1993 policy statement to describe the
responsibilities of the boards of directors and management of banks and
savings associations and of examiners regarding the ALLL. This revision
replaces the 1993 policy statement and also makes it applicable to
credit unions. In addition, the agencies are issuing the attached
frequently asked questions (FAQs) to assist institutions in complying
with GAAP and ALLL supervisory guidance.
Background
This policy statement reiterates key concepts and requirements
included in GAAP and existing ALLL supervisory
guidance. 2
The principal sources of guidance on accounting for impairment in a
loan portfolio under GAAP are Statement of Financial Accounting
Standards No. 5, Accounting for Contingencies (FAS 5), and
Statement of Financial Accounting Standards No. 114, Accounting
by Creditors for Impairment of a Loan (FAS 114). In addition, the
Financial Accounting Standards Board Viewpoints article that
is included in Emerging Issues Task Force Topic D--80 (EITF D--80),
Application of FASB Statements No. 5 and No. 114 to a Loan
Portfolio, presents questions and answers that provide specific
guidance on the interaction between these two FASB statements and may
be helpful in applying them.
In July 1999, the banking agencies and the Securities and Exchange
Commission (SEC) issued a Joint Interagency Letter to Financial
Institutions. The letter stated that the banking agencies and the SEC
agreed on the following important aspects of loan loss allowance
practices:
Arriving at an appropriate allowance involves a high degree
of management judgment and results in a range of estimated losses;
Prudent, conservative, but not excessive, loan loss
allowances that fall within an acceptable range of estimated losses are
appropriate. In accordance with GAAP, an institution should record its
best estimate within the range of credit losses, including when
management's best estimate is at the high end of the range;
Determining the allowance for loan losses is inevitably
imprecise, and an appropriate allowance falls within a range of
estimated losses;
An "unallocated" loan loss allowance is appropriate
when it reflects an estimate of probable losses, determined in
accordance with GAAP, and is properly supported;
Allowance estimates should be based on a comprehensive,
well-documented, and consistently applied analysis of the loan
portfolio; and
The loan loss allowance should take into consideration all
available information existing as of the financial statement date,
including environmental factors such as industry, geographical,
economic, and political factors.
{{12-29-06 p.5454}}
In July 2001, the banking agencies issued a Policy Statement
on Allowance for Loan and Lease Losses Methodologies and Documentation
for Banks and Savings Institutions (2001 Policy Statement). It is
designed to assist institutions in establishing a sound process for
determining an appropriate ALLL and documenting that process in
accordance with GAAP. 3
The guidance in the 2001 Policy Statement was substantially adopted by
the NCUA through its Interpretative Ruling and Policy Statement 02--3,
Allowance for Loan and Lease Losses Methodologies and
Documentation for Federally Insured Credit Unions in May 2002
(NCUA's 2002 IRPS).
In March 2004, the agencies issued an Update on Accounting for
Loan and Lease Losses. This guidance provided reminders of long
standing supervisory guidance as well as a listing of the existing
allowance guidance that institutions should continue to apply.
Nature and Purpose of the ALLL
The ALLL represents one of the most significant estimates in an
institution's financial statements and regulatory reports. Because of
its significance, each institution has a responsibility for developing,
maintaining, and documenting a comprehensive, systematic, and
consistently applied process for determining the amounts of the ALLL
and the provision for loan and lease losses (PLLL). To fulfill this
responsibility, each institution should ensure controls are in place to
consistently determine the ALLL in accordance with GAAP, the
institution's stated policies and procedures, management's best
judgment and relevant supervisory guidance.
As of the end of each quarter, or more frequently if warranted, each
institution must analyze the collectibility of its loans and leases
held for investment 4
(hereafter referred to as "loans") and maintain an ALLL at a
level that is appropriate and determined in accordance with GAAP. An
appropriate ALLL covers estimated credit losses on individually
evaluated loans that are determined to be impaired as well as estimated
credit losses inherent in the remainder of the loan and lease
portfolio. The ALLL does not apply, however, to loans carried at fair
value, loans held for sale, 5
off-balance sheet credit exposures 6
(e.g. financial instruments such as off-balance sheet loan commitments,
standby letters of credit, and guarantees), or general or unspecified
business risks.
For purposes of this policy statement, the term "estimated credit
losses" means an estimate of the current amount of loans that it is
probable the institution will be unable to collect given facts and
circumstances as of the evaluation date. Thus, estimated credit losses
represent net charge-offs that are likely to be realized for a loan or
group of loans. These estimated credit losses should meet the criteria
for accrual of a loss contingency (i.e., through a provision to the
ALLL) set forth in GAAP. 7
When available information confirms
{{12-29-06 p.5455}}that specific loans, or portions thereof, are
uncollectible, these amounts should be promptly charged off against the
ALLL.
For "purchased impaired
loans," 8
GAAP prohibits "carrying over" or creating an ALLL in the initial
recording of these loans. However, if, upon evaluation subsequent to
acquisition, it is probable that the institution will be unable to
collect all cash flows expected at acquisition on a purchased impaired
loan (an estimate that considers both timing and amount), the loan
should be considered impaired for purposes of applying the measurement
and other provisions of FAS 5 or, if applicable, FAS 114.
Estimates of credit losses should reflect consideration of all
significant factors that affect the collectibility of the portfolio as
of the evaluation date. For loans within the scope of FAS 114 that are
individually evaluated and determined to be
impaired, 9
these estimates should reflect consideration of one of the standard's
three impairment measurement methods as of the evaluation date: (1) the
present value of expected future cash flows discounted at the loan's
effective interest rate, 10
(2) the loan's observable market price, or (3) the fair value of the
collateral if the loan is collateral dependent.
An institution may choose the appropriate FAS 114 measurement method
on a loan-by-loan basis for an individually impaired loan, except for
an impaired collateral-dependent loan. The agencies require impairment
of a collateral-dependent loan to be measured using the fair value of
collateral method. As defined in FAS 114, a loan is collateral
dependent if repayment of the loan is expected to be provided solely by
the underlying collateral. In general, any portion of the recorded
investment in a collateral-dependent loan (including any capitalized
accrued interest, net deferred loan fees or costs, and unamortized
premium or discount) in excess of the fair value of the collateral that
can be identified as uncollectible, and is therefore deemed a confirmed
loss, should be promptly charged off against the
ALLL. 11
All other loans, including individually evaluated loans determined
not to be impaired under FAS 114, should be included in a group of
loans that is evaluated for impairment under FAS
5. 12
While an institution may segment its loan portfolio into groups of
loans
{{12-29-06 p.5456}}based on a variety of factors, the loans
within each group should have similar risk characteristics. For
example, a loan that is fully collateralized with risk-free assets
should not be grouped with uncollateralized loans. When estimating
credit losses on each group of loans with similar risk characteristics,
an institution should consider its historical loss experience on the
group, adjusted for changes in trends, conditions, and other
relevant factors that affect repayment of the loans as of the
evaluation date.
For analytical purposes, an institution should attribute portions of
the ALLL to loans that it evaluates and determines to be impaired under
FAS 114 and to groups of loans that it evaluates collectively under FAS
5. However, the ALLL is available to cover all charge-offs that arise
from the loan portfolio.
Responsibilities of the Board of Directors and
Management
Appropriate ALLL Level
Each institution's management is responsible for maintaining the
ALLL at an appropriate level and for documenting its analysis according
to the standards set forth in the 2001 Policy Statement or the NCUA's
2002 IRPS, as applicable. Thus, management should evaluate the ALLL
reported on the balance sheet as of the end of each quarter (and for
credit unions, prior to paying dividends), or more frequently if
warranted, and charge or credit the PLLL to bring the ALLL to an
appropriate level as of each evaluation date. The determination of the
amounts of the ALLL and the PLLL should be based on management's
current judgments about the credit quality of the loan portfolio, and
should consider all known relevant internal and external factors that
affect loan collectibility as of the evaluation date. Management's
evaluation is subject to review by examiners. An institution's failure
to analyze the collectibility of the loan portfolio and maintain and
support an appropriate ALLL in accordance with GAAP and supervisory
guidance is generally an unsafe and unsound practice.
In carrying out its responsibility for maintaining an appropriate
ALLL, management is expected to adopt and adhere to written policies
and procedures that are appropriate to the size of the institution and
the nature, scope, and risk of its lending activities. At a minimum,
these policies and procedures should ensure that:
The institution's process for determining an appropriate
level for the ALLL is based on a comprehensive, well-documented, and
consistently applied analysis of its loan
portfolio. 13
The analysis should consider all significant factors that affect the
collectibility of the portfolio and should support the credit losses
estimated by this process.
The institution has an effective loan review system and
controls (including an effective loan classification or credit grading
system) that identify, monitor, and address asset quality problems in
an accurate and timely manner. 14
To be effective, the institution's loan review system and controls
must be responsive to changes in internal and external factors
affecting the level of credit risk in the portfolio.
The institution has adequate data capture and reporting
systems to supply the information necessary to support and document its
estimate of an appropriate ALLL.
The institution evaluates any loss estimation models before
they are employed and modifies the models' assumptions, as needed, to
ensure that the resulting loss estimates are consistent with GAAP. To
demonstrate this consistency, the institution should document its
evaluations and conclusions regarding the appropriateness of
estimating
{{12-29-06 p.5457}}credit losses with the models or other
estimation tools. The institution should also document and support any
adjustments made to the models or to the output of the models in
determining the estimated credit losses.
The institution promptly charges off loans, or portions of
loans, that available information confirms to be uncollectible.
The institution periodically validates the ALLL
methodology. This validation process should include procedures for a
review, by a party who is independent of the institution's credit
approval and ALLL estimation processes, of the ALLL methodology and its
application in order to confirm its effectiveness. A party who is
independent of these processes could be the internal audit staff, a
risk management unit of the institution, an external auditor (subject
to applicable auditor independence standards), or another contracted
third party from outside the institution. One party need not perform
the entire analysis as the validation can be divided among various
independent parties.
The board of directors is responsible for overseeing management's
significant judgments and estimates pertaining to the determination of
an appropriate ALLL. This oversight should include but is not limited
to:
Reviewing and approving the institution's written ALLL
policies and procedures at least annually.
Reviewing management's assessment and justification that
the loan review system is sound and appropriate for the size and
complexity of the institution.
Reviewing management's assessment and justification for
the amounts estimated and reported each period for the PLLL and the
ALLL.
Requiring management to periodically validate and, when
appropriate, revise the ALLL methodology.
For purposes of the Reports of Condition and Income (Call Report),
the Thrift Financial Report (TFR), and the NCUA Call Report (5300) an
appropriate ALLL (after deducting all loans and portions of loans
confirmed loss) should consist only of the following components (as
applicable), 15
the amounts of which take into account all relevant facts and
circumstances as of the evaluation date:
For loans within the scope of FAS 114 that are individually
evaluated and found to be impaired, the associated ALLL should be based
upon one of the three impairment measurement methods specified in FAS
114. 16
For all other loans, including individually evaluated loans
determined not to be impaired under FAS
114, 17
the associated ALLL should be measured under FAS 5 and should provide
for all estimated credit losses that have been incurred on groups of
loans with similar risk characteristics.
For estimated credit losses from transfer risk on
cross-border loans, the impact to the ALLL should be evaluated
individually for impaired loans under FAS 114 or evaluated on a group
basis under FAS 5. See Attachment 2 for further guidance on
considerations of transfer risk on cross-border loans.
For estimated credit losses on accrued interest and fees on
loans that have been reported as part of the respective loan balances
on the institution's balance sheet, the associated ALLL should be
evaluated under FAS 114 or FAS 5 as appropriate, if not already
included in one of the preceding components.
Because deposit accounts that are overdrawn (i.e. overdrafts) must
be reclassified as loans on the balance sheet, overdrawn accounts
should be included in one of the first two components above, as
appropriate, and evaluated for estimated credit losses.
Determining the appropriate level for the ALLL is inevitably
imprecise and requires a high degree of management judgment.
Management's analysis should reflect a prudent, conservative, but not
excessive ALLL that falls within an acceptable range of
estimated
{{12-29-06 p.5458}}credit losses. When a range of losses is
determined, institutions should maintain appropriate documentation to
support the identified range and the rationale used for determining the
best estimate from within the range of loan losses.
As discussed more fully in Attachment 1, it is essential that
institutions maintain effective loan review systems. An effective loan
review system should work to ensure the accuracy of internal credit
classification or grading systems and, thus, the quality of the
information used to assess the appropriateness of the ALLL. The
complexity and scope of an institution's ALLL evaluation process, loan
review system, and other relevant controls should be appropriate for
the size of the institution and the nature of its lending activities.
The evaluation process should also provide for sufficient flexibility
to respond to changes in the factors that affect the collectibility of
the portfolio.
Credit losses that arise from the transfer risk associated with an
institution's cross-border lending activities require special
consideration. In particular, for banks with cross-border lending
exposure, management should determine that the ALLL is appropriate to
cover estimated losses from transfer risk associated with this exposure
over and above any minimum amount that the Interagency Country Exposure
Review Committee requires to be provided in the Allocated Transfer Risk
Reserve (or charged off against the ALLL). These estimated losses
should meet the criteria for accrual of a loss contingency set forth in
GAAP. (See Attachment 2 for factors to consider.)
Factors to Consider in the Estimation of Credit Losses
Estimated credit losses should reflect consideration of all
significant factors that affect the collectibility of the portfolio as
of the evaluation date. Normally, an institution should determine the
historical loss rate for each group of loans with similar risk
characteristics in its portfolio based on its own loss experience for
loans in that group. While historical loss experience provides a
reasonable starting point for the institution's analysis, historical
losses, or even recent trends in losses, do not by themselves form a
sufficient basis to determine the appropriate level for the ALLL.
Management should also consider those qualitative or environmental
factors that are likely to cause estimated credit losses associated
with the institution's existing portfolio to differ from historical
loss experience, including but not limited to:
Changes in lending policies and procedures, including
changes in underwriting standards and collection, charge-off, and
recovery practices not considered elsewhere in estimating credit
losses.
Changes in international, national, regional, and local
economic and business conditions and developments that affect the
collectibility of the portfolio, including the condition of various
market segments. 18
Changes in the nature and volume of the portfolio and in
the terms of loans.
Changes in the experience, ability, and depth of lending
management and other relevant staff.
Changes in the volume and severity of past due loans, the
volume of nonaccrual loans, and the volume and severity of adversely
classified or graded loans. 19
Changes in the quality of the institution's loan review
system.
Changes in the value of underlying collateral for
collateral-dependent loans.
The existence and effect of any concentrations of credit,
and changes in the level of such concentrations.
The effect of other external factors such as competition
and legal and regulatory requirements on the level of estimated credit
losses in the institution's existing portfolio.
{{12-29-06 p.5459}}
In addition, changes in the level of the ALLL should be
directionally consistent with changes in the factors, taken as a whole,
that evidence credit losses, keeping in mind the characteristics of an
institution's loan portfolio. For example, if declining credit quality
trends relevant to the types of loans in an institution's portfolio
are evident, the ALLL level as a percentage of the portfolio should
generally increase, barring unusual charge-off activity. Similarly, if
improving credit quality trends are evident, the ALLL level as a
percentage of the portfolio should generally decrease.
Measurement of Estimated Credit Losses
FAS 5
When measuring estimated credit losses on groups of loans with
similar risk characteristics in accordance with FAS 5, a widely used
method is based on each group's historical net charge-off rate
adjusted for the effects of the qualitative or environmental factors
discussed previously. As the first step in applying this method,
management generally bases the historical net charge-off rates on the
"annualized" historical gross loan charge-offs, less recoveries,
recorded by the institution on loans in each group.
Methodologies for determining the historical net charge-off rate on
a group of loans with similar risk characteristics under FAS 5 can
range from the simple average of, or a determination of the range of,
an institution's annual net charge-off experience to more complex
techniques, such as migration analysis and models that estimate credit
losses. 20
Generally, institutions should use at least an "annualized" or
12-month average net charge-off rate that will be applied to the groups
of loans when estimating credit losses. However, this rate could vary.
For example, loans with effective lives longer than 12 months often
have workout periods over an extended period of time, which may
indicate that the estimated credit losses should be greater than that
calculated based solely on the annualized net charge-off rate for such
loans. These groups may include certain commercial loans as well as
groups of adversely classified loans. Other groups of loans may have
effective lives shorter than 12 months, which may indicate that the
estimated credit losses should be less than that calculated based on
the annualized net charge-off rate.
Regardless of the method used, institutions should maintain
supporting documentation for the techniques used to develop the
historical loss rate for each group of loans. If a range of historical
loss rates is developed instead for a group of loans, institutions
should maintain documentation to support the identified range and the
rationale for determining which rate is the best estimate within the
range of loss rates. The rationale should be based on management's
assessment of which rate is most reflective of the estimated credit
losses in the current loan portfolio.
After determining the appropriate historical loss rate for each
group of loans with similar risk characteristics, management should
consider those current qualitative or environmental factors that are
likely to cause estimated credit losses as of the evaluation date to
differ from the group's historical loss experience. Institutions
typically reflect the overall effect of these factors on a loan group
as an adjustment that, as appropriate, increases or decreases the
historical loss rate applied to the loan group. Alternatively, the
effect of these factors may be reflected through separate standalone
adjustments within the FAS 5 component of
{{12-29-06 p.5460}}the
ALLL. 21
Both methods are consistent with GAAP provided the adjustments for
qualitative or environmental factors are reasonably and consistently
determined, are adequately documented, and represent estimated credit
losses. For each group of loans, an institution should apply its
adjusted historical loss rate, or its historical loss rate and separate
standalone adjustments, to the recorded investment in the group when
determining its estimated credit losses.
Management must exercise significant judgment when evaluating the
effect of qualitative factors on the amount of the ALLL because data
may not be reasonably available or directly applicable for management
to determine the precise impact of a factor on the collectibility of
the institution's loan portfolio as of the evaluation date.
Accordingly, institutions should support adjustments to historical loss
rates and explain how the adjustments reflect current information,
events, circumstances, and conditions in the loss measurements.
Management should maintain reasonably documentation to support which
factors affected the analysis and the impact of those factors on the
loss measurement. Support and documentation includes descriptions of
each factor, management's analysis of how each factor has changed over
time, which loan groups' loss rates have been adjusted, the amount by
which loss estimates have been adjusted for changes in conditions, an
explanation of how management estimated the impact, and other available
data that supports the reasonableness of the adjustments. Examples of
underlying supporting evidence could include, but are not limited to,
relevant articles from newspapers and other publications that describe
economic events affecting a particular geographic area, economic
reports and data, and notes from discussions with borrowers.
There may be times when an institution does not have its own
historical loss experience upon which to base its estimate of the
credit losses in a group of loans with similar risk characteristics.
This may occur when an institution offers a new loan product or in the
case of a newly established (i.e., de novo) institution. If an
institution has no experience of its own for a loan group, reference to
the experience of other enterprises in the same lending business may be
appropriate, provided the institution demonstrates that the attributes
of the group of loans in its portfolio are similar to those of the loan
group in the portfolio providing the loss experience. An institution
should only use another enterprise's experience on a short-term basis
until it has developed its own loss experience for a particular group
of loans.
FAS 114
When determining the FAS 114 component of the ALLL for an
individually impaired loan, 22
an institution should consider estimated costs to sell the loan's
collateral, if any, on a discounted basis, in the measurement of
impairment if those costs are expected to reduce the cash flows
available to repay or otherwise satisfy the loan. If the institution
bases its measure of loan impairment on the present value of expected
future cash flows discounted at the loan's effective interest rate,
the estimates of these cash flows should be the institution's best
estimate based on reasonable and supportable assumptions and
projections. All available evidence should be considered in developing
the estimate of expected future cash flows. The weight given to the
evidence should be commensurate with the extent to which the evidence
can be verified objectively. The likelihood of the possible outcomes
should be considered in determining the best estimate of expected
future cash flows.
{{12-29-06 p.5461}}
Analyzing the Overall Measurement of the ALLL
Institutions are also encouraged to use ratio analysis as a
supplemental tool for evaluating the overall reasonableness of the
ALLL. Ratio analysis can be useful in identifying divergent trends
(compared with an institution's peer group and its own historical
experience) in the relationship of the ALLL to adversely classified or
graded loans, past due and nonaccrual loans, total loans, and
historical gross and net charge-offs. Based on such analysis, an
institution may identify additional issues or factors that previously
had not been considered in the ALLL estimation process, which may
warrant adjustments to estimated credit losses. Such adjustments should
be appropriately supported and documented.
While ratio analysis, when used prudently, can be helpful as a
supplemental check on the reasonableness of management's assumptions
and analyses, it is not a sufficient basis for determining the
appropriate amount for the ALLL. In particular, because an appropriate
ALLL is an institution-specific amount, such comparisons do not obviate
the need for a comprehensive analysis of the loan portfolio and the
factors affecting its collectibility. Furthermore, it is inappropriate
for the board of directors or management to make adjustments to the
ALLL when it has been properly computed and supported under the
institution's methodology for the sole purpose of reporting an ALLL
that corresponds to the peer group median, a target ratio, or a
budgeted amount. Institutions that have high levels of risk in the loan
portfolio or are uncertain about the effect of possible future events
on the collectibility of the portfolio should address these concerns by
maintaining higher equity capital and not by arbitrarily increasing the
ALLL in excess of amounts supported under
GAAP. 23
Estimated Credit Losses in Credit Related Accounts
Typically, institutions evaluate and estimate credit losses for
off-balance sheet credit exposures at the same time that they estimate
credit losses for loans. While a similar process should be followed to
support loss estimates related to off-balance sheet exposures, these
estimated credit losses are not recorded as part of the ALLL. When the
conditions for accrual of a loss under FAS 5 are met, an institution
should maintain and report as a separate liability account, an
allowance that is appropriate to cover estimated credit losses on
off-balance sheet loan commitments, standby letters of credit, and
guarantees. In addition, recourse liability accounts (that arise from
recourse obligations on any transfers of loans that are reported as
sales in accordance with GAAP) should be reported in regulatory reports
as liabilities that are separate and distinct from both the ALLL and
the allowance for credit losses on off-balance sheet credit exposures.
When accrued interest and fees are reported separately on an
institution's balance sheet from the related loan balances (i.e., as
other assets), the institution should maintain an appropriate valuation
allowance, determined in accordance with GAAP, for amounts that are not
likely to be collected unless management has placed the underlying
loans in nonaccrual status and reversed previously accrued interest and
fees. 24
Responsibilities of Examiners
Examiners should assess the credit quality of an institution's loan
portfolio, the appropriateness of its ALLL methodology and
documentation, and the appropriateness of the reported ALLL in the
institution's regulatory reports. In their review and classification
or grading of the loan portfolio, examiners should consider all
significant factors that affect the
{{12-29-06 p.5462}}collectibility of the portfolio, including
the value of any collateral. In reviewing the appropriateness of the
ALLL, examiners should:
Consider the effectiveness of board oversight as well as
the quality of the institution's loan review system and management in
identifying, monitoring, and addressing asset quality problems. This
will include a review of the institution's loan review function and
credit grading system. Typically, this will involve testing a sample of
the institution's loans. The sample size generally varies and will
depend on the nature or purpose of the
examination. 25
Evaluate the institution's ALLL policies and procedures
and assess the methodology that management uses to arrive at an overall
estimate of the ALLL, including whether management's assumptions,
valuations, and judgments appear reasonable and are properly supported.
If a range of credit losses has been estimated by management, evaluate
the reasonableness of the range and management's best estimate within
the range. In making these evaluations, examiners should ensure that
the institution's historical loss experience and all significant
qualitative or environmental factors that affect the collectibility of
the portfolio (including changes in the quality of the institution's
loan review function and the other factors previously discussed) have
been appropriately considered and that management has appropriately
applied GAAP, including FAS 114 and FAS 5.
Review management's use of loss estimation models or other
loss estimation tools to ensure that the resulting estimated credit
losses are in conformity with GAAP.
Review the appropriateness and reasonableness of the
overall level of the ALLL. In some instances this may include a
quantitative analysis (e.g., using the types of ratio analysis
previously discussed) as a preliminary check on the reasonableness of
the ALLL. This quantitative analysis should demonstrate whether changes
in the key ratios from prior periods are reasonable based on the
examiner's knowledge of the collectibility of loans at the institution
and its current environment.
Review the ALLL amount reported in the institution's
regulatory reports and financial statements and ensure these amounts
reconcile to its ALLL analyses. There should be no material differences
between the consolidated loss estimate, as determined by the ALLL
methodology, and the final ALLL balance reported in the financial
statements. Inquire about reasons for any material differences between
the results of the institution's ALLL analyses and the institution's
reported ALLL to determine whether the differences can be
satisfactorily explained.
Review the adequacy of the documentation and controls
maintained by management to support the appropriateness of the ALLL.
Review the interest and fee income accounts associated with
the lending process to ensure that the institution's net income is not
materially misstated. 26
As noted in the "Responsibilities of the Board of Directors and
Management" section of this policy statement, when assessing the
appropriateness of the ALLL, it is important to recognize that the
related process, methodology, and underlying assumptions require a
substantial degree of management judgment. Even when an institution
maintains sound loan administration and collection procedures and an
effective loan review system and controls, its estimate of credit
losses is not a single precise amount due to the wide range of
qualitative or environmental factors that must be
considered.
{{12-29-06 p.5462.01}}
An institution's ability to estimate credit losses on specific
loans and groups of loans should improve over time as substantive
information accumulates regarding the factors affecting repayment
prospects. Therefore, examiners should generally accept management's
estimates when they assess the appropriateness of the institution's
reported ALLL, and not seek adjustments to the ALLL, when management
has:
Maintained effective loan review systems and controls for
identifying, monitoring and addressing asset quality problems in a
timely manner.
Analyzed all significant qualitative or environmental
factors that affect the collectibility of the portfolio as of the
evaluation date in a reasonable manner.
Established an acceptable ALLL evaluation process for both
individual loans and groups of loans that meets the GAAP requirements
for an appropriate ALLL.
Incorporated reasonable and properly supported assumptions,
valuations, and judgments into the evaluation process.
If the examiner concludes that the reported ALLL level is not
appropriate or determines that the ALLL evaluation process is based on
the results of an unreliable loan review system or is otherwise
deficient, recommendations for correcting these deficiencies, including
any examiner concerns regarding an appropriate level for the ALLL,
should be noted in the report of examination. The examiner's comments
should cite any departures from GAAP and any contraventions of this
policy statement and the 2001 Policy Statement or the NCUA's 2002
IRPS, as applicable. Additional supervisory action may also be taken
based on the magnitude of the observed shortcomings in the ALLL
process, including the materiality of any error in the reported amount
of the ALLL.
ALLL Level Reflected in Regulatory Reports
The agencies believe that an ALLL established in accordance with
this policy statement and the 2001 Policy Statement or the NCUA's 2002
IRPS, as applicable, falls within the range of acceptable estimates
determined in accordance with GAAP. When the reported amount of an
institution's ALLL is not appropriate, the institution will be
required to adjust its ALLL by an amount sufficient to bring the ALLL
reported on its Call Report, TFR, or 5300 to an appropriate level as of
the evaluation date. This adjustment should be reflected in the current
period provision or through the restatement of prior period provisions,
as appropriate in the circumstances.
Paperwork Reduction Act
The agencies do not intend this policy statement and the FAQs to
create any new information collection requirements under the Paperwork
Reduction Act. To the extent this policy statement and the FAQs involve
information collection requirements, they are already required by GAAP
or existing information collections for which the agencies have jointly
or individually received approval.
Attachment 1 Loan Review Systems
The nature of loan review systems may vary based on an
institution's size, complexity, loan types, and management
practices. 27
For example, a loan review system may include components of a
traditional loan review function that is independent of the lending
function, or it may place some reliance on loan officers. In addition,
the use of the term "loan
{{12-29-06 p.5462.02}}review system" can refer to various
responsibilities assigned to credit administration, loan
administration, a problem loan workout group, or other areas of an
institution. These responsibilities may range from administering the
internal problem loan reporting process to maintaining the integrity of
the loan classification or credit grading process (e.g., ensuring that
timely and appropriate changes are made to the loan classifications or
credit grades assigned to loans) and coordinating the gathering of the
information necessary to assess the appropriateness of the ALLL.
Additionally, some or all of this function may be outsourced to a
qualified external loan reviewer. Regardless of the structure of the
loan review system in an institution, an effective loan review system
should have, at a minimum, the following objectives:
To promptly identify loans with potential credit
weaknesses.
To appropriately grade or adversely classify loans,
especially those with well-defined credit weaknesses that jeopardize
repayment, so that timely action can be taken and credit losses can be
minimized.
To identify relevant trends that affect the collectibility
of the portfolio and isolate segments of the portfolio that are
potential problem areas.
To assess the adequacy of and adherence to internal credit
policies and loan administration procedures and to monitor compliance
with relevant laws and regulations.
To evaluate the activities of lending personnel including
their compliance with lending policies and the quality of their loan
approval, monitoring, and risk assessment.
To provide senior management and the board of directors
with an objective and timely assessment of the overall quality of the
loan portfolio.
To provide management with accurate and timely credit
quality information for financial and regulatory reporting purposes,
including the determination of an appropriate ALLL.
Loan Classification or Credit Grading Systems
The foundation for any loan review system is accurate and timely
loan classification or credit grading, which involves an assessment of
credit quality and leads to the identification of problem loans. An
effective loan classification or credit grading system provides
important information on the collectibility of the portfolio for use in
the determination of an appropriate level for the ALLL.
Regardless of the type of loan review system employed, an effective
loan classification or credit grading framework generally places
primary reliance on the institution's lending staff to identify
emerging loan problems. However, given the importance and subjective
nature of loan classification or credit grading, the judgment of an
institution's lending staff regarding the assignment of particular
classification or grades to loans should be subject to review by: (i)
peers, superiors, or loan committee(s); (ii) an independent, qualified
part-time or full-time empolyee(s); (iii) an internal department
staffed with credit review specialists; or (iv) qualified outside
credit review consultants. A loan classification or credit grading
review that is independent of the lending function is preferred because
it typically provides a more objective assessment of credit quality.
Because accurate and timely loan classification or credit grading is a
critical component of an effective loan review system, each institution
should ensure that its loan review system includes the following
attributes:
A formal loan classification or credit grading system in
which loan classifications or credit grades reflect the risk of default
and credit losses and for which a written description is maintained,
including a discussion of the factors used to assign appropriate
classifications or credit grades to
loans. 28
{{12-29-06 p.5462.03}}
Identification or grouping of loans that warrant the
special attention of
management 29
or other designated "watch lists" of loans that management is
more closely monitoring.
Documentation supporting the reasons why particular loans
merit special attention or received a specific adverse classification
or credit grade and management's adherence to approved work out plans.
A mechanism for direct, periodic, and timely reporting to
senior management and the board of directors on the status of loans
identified as meriting special attention or adversely classified or
graded and the actions taken by management.
Appropriate documentation of the institution's historical
loss experience for each of the groups of loans with similar risk
characteristics into which it has segmented its loan
portfolio. 30
Elements of Loan Review Systems
Each institution should have a written policy that is reviewed and
approved at least annually by the board of directors to evidence its
support of and commitment to maintaining an effective loan review
system. The loan review policy should address the following elements
which are described in more detail below: the qualifications and
independence of loan review personnel; the frequency, scope and depth
of reviews; the review of findings and follow-up; and workpaper and
report distribution.
Qualifications of Loan Review Personnel
Persons involved in the loan review or credit grading function
should be qualified based on their level of education, experience, and
extent of formal credit training. They should be knowledgeable in both
sound lending practices and the institution's lending guidelines for
the types of loans offered by the institution. In addition, they should
be knowledgeable of relevant laws and regulations affecting lending
activities.
Independence of Loan Review Personnel
An effective loan review system uses both the initial identification
of emerging problem loans by loan officers and other line staff, and
the credit review of loans by individuals independent of the credit
approval process. An important requirement for an effective system is
to place responsibility on loan officers and line staff for continuous
portfolio analysis and prompt identification and reporting of problem
loans. Because of frequent contact with borrowers, loan officers and
line staff can usually identify potential problems before they become
apparent to others. However, institutions should be careful to avoid
over-reliance upon loan officers and line staff for identification of
problem loans. Institutions should ensure that loans are also reviewed
by individuals who do not have control over the loans they review and
who are not part of, and are not influenced by anyone associated with
the loan approval process.
While larger institutions typically establish a separate department
staffed with credit review specialists, cost and volume considerations
may not justify such a system in smaller institutions. In some smaller
institutions, an independent committee of outside directors may fill
this role. Whether or not the institution has an independent loan
review department, the loan review function should report
directly to the board of directors or a committee thereof
(although senior management may be responsible for appropriate
administrative functions so long as they do not compromise the
independence of the loan review function).
Some institutions may choose to outsource the credit review function
to an independent outside party. However, the responsibility for
maintaining a sound loan review process cannot be delegated to an
outside party. Therefore, institution personnel who are independent of
the lending function should assess control risks, develop the credit
review plan, and
{{12-29-06 p.5462.04}}ensure appropriate follow-up of findings.
Furthermore, the institution should be mindful of special requirements
concerning independence should it consider outsourcing the credit
review function to its external auditor.
Frequency of Reviews
Loan review personnel should review significant
credits 31
at least annually, upon renewal, or more frequently when internal or
external factors indicate a potential for deteriorating credit quality
in a particular loan, loan product, or group of loans. Optimally, the
loan review function can be used to provide useful continual feedback
on the effectiveness of the lending process in order to identify any
emerging problems. A system of ongoing or periodic portfolio reviews is
particularly important to the ALLL determination process because this
process is dependent on the accurate and timely identification of
problem loans.
Scope of Reviews
Reviews by loan review personnel should cover all loans that are
significant and other loans that meet certain criteria. Management
should document the scope of its reviews and ensure that the percentage
of the portfolio selected for review provides reasonable assurance that
the results of the review have identified any credit quality
deterioration and other unfavorable trends in the portfolio and reflect
its quality as a whole. Management should also consider industry
standards for loan review coverage consistent with the size and
complexity of its loan portfolio and lending operations to verify that
the scope of its reviews is appropriate. The institution's board of
directors should approve the scope of loan reviews on an annual basis
or when any significant interim changes to the scope of reviews are
made. Reviews typically include:
Loans over a predetermined size.
A sufficient sample of smaller loans.
Past due, nonaccrual, renewed and restructured loans.
Loans previously adversely classified or graded and loans
designated as warranting the special attention of
management 32
by the institution or its examiners.
Insider loans.
Loans constituting concentrations of credit risk and other
loans affected by common repayment factors.
Depth of Reviews
Reviews should analyze a number of important aspects of the loans
selected for review, including:
Credit quality, including underwriting and borrower
performance.
Sufficiency of credit and collateral documentation.
Proper lien perfection.
Proper approval by the loan officer and loan committee(s).
Adherence to any loan agreement covenants.
Compliance with internal policies and procedures (such as
aging, nonaccrual, and classification or grading policies) and laws and
regulations.
Appropriate identification of individually impaired loans,
measurement of estiamted loan impairment, and timeliness of
charge-offs.
Furthermore, these reviews should consider the appropriateness and
timeliness of the identification of problem loans by loan officers.
Review of Findings and Follow-Up
Loan review personnel should discuss all noted deficiencies and
identified weaknesses and any existing or planned corrective actions,
including time frames for correction, with appropriate loan officers
and department managers. Loan review personnel should then review these
findings and corrective actions with members of senior management. All
noted
{{12-29-06 p.5462.05}}deficiencies and identified weaknesses that
remain unsolved beyond the scheduled time frames for correction should
be promptly reported to senior management and the board of directors.
Credit classification or grading differences between loan officers
and loan review personnel should be resolved according to a
pre-arranged process. That process may include formal appeals
procedures and arbitration by an independent party or may require
default to the assigned classification or grade that indicates lower
credit quality. If an outsourced credit review concludes that a
borrower is less creditworthy than is perceived by the institution, the
lower credit quality classification or grade should prevail unless
internal parties identify additional information sufficient to obtain
the concurrence of the outside reviewer or arbiter on the higher credit
quality classification or grade.
Workpaper and Report Distribution
The loan review function should prepare a list of all loans reviewed
(including the date of the review) and documentation (including a
summary analysis) that substantiates the grades or classifications
assigned to the loans reviewed. A report that summarizes the results of
the loan review should be submitted to the board of directors at least
quarterly. 33
In addition to reporting current credit quality findings, comparative
trends can be presented to the board of directors that identify
significant changes in the overall quality of the portfolio. Findings
should also address the adequacy of and adherence to internal policies
and procedures, as well as compliance with laws and regulations, in
order to facilitate timely correction of any noted deficiencies.
Attachment 2 International Transfer Risk Considerations
With respect to international transfer risk, an institution with
cross-border exposures should support its determination of the
appropriateness of its ALLL by performing an analysis of the transfer
risk, commensurate with the size and composition of the institution's
exposure to each country. Such analyses should take into consideration
the following factors, as appropriate:
The institution's loan portfolio mix for each country
(e.g., types of borrowers, loan maturities, collateral, guarantees,
special credit facilities, and other distinguishing factors).
The institution's business strategy and its debt
management plans for each country.
Each country's balance of payments position.
Each country's level of international reserves.
Each country's established payment performance record and
its future debt servicing prospects.
Each country's socio-political situation and its effect on
the adoption or implementation of economic reforms, in particular those
affecting debt servicing capacity.
Each country's current standing with multilateral and
official creditors.
The status of each country's relationship with other
creditors, including institutions.
The most recent evaluations distributed by the banking
agencies' Interagency Country Exposure Review Committee.
[Source: FDIC Financial Institution Letter (FIL--105--2006), dated
December 13, 2006]
Questions and Answers on Accounting for Loan and Lease Losses
Purpose
The staffs of the Office of the Comptroller of the Currency, the
Board of Governors of the Federal Reserve System, the Federal Deposit
Insurance Corporation, the National Credit Union Administration (NCUA),
and the Office of Thrift Supervision (collectively, the
"agencies") are providing interpretive answers to frequently
asked questions regarding the
{{12-29-06 p.5462.06}}accounting for loan and lease losses and
troubled loans for regulatory reporting purposes by federally insured
depository institutions ("institutions"). The agencies are
issuing these questions and answers in conjunction with the issuance of
a revised "Interagency Policy Statement on the Allowance for Loan
and Lease Losses" (2006 Policy Statement). These questions and
answers focus on topics about which examiners, institutions, and
accountants frequently inquire concerning the allowance for loan and
lease losses (ALLL). The questions and answers are grouped into subject
areas that are presented in the same order as the sections in the 2006
Policy Statement as
follows:
Section
of the 2006 Policy Statement: |
Questions: |
Page Numbers: |
Nature
and Purpose of the ALLL |
1 |
2 |
Responsibilities of the Board of
Directors and Management: |
|
|
Appropriate ALLL
Level |
2--8 |
2--6 |
Factors to Consider in the Estimation of
Credit Losses |
9--10 |
7--8 |
Measurement of Estimated Credit
Losses |
11--16 |
8--12
|
The staffs' interpretive answers are based on existing
sources of generally accepted accounting principles (GAAP) and related
supervisory policies. The answers are not intended to establish new
accounting guidance. Readers should refer to the accounting literature
and supervisory policies cited in the responses for complete guidance
and information. As mentioned in the 2006 Policy Statement the
principal sources of guidance on accounting for impairment in a loan
portfolio under GAAP are Statement of Financial Accounting Standards
No. 114, Accounting by Creditors for Impairment of a Loan
(FAS 114), and Statement of Financial Accounting Standards No. 5,
Accounting for Contingencies (FAS 5) as well as the
Financial Accounting Standards Board (FASB) Viewpoints
article included in Emerging Issues Task Force (EITF) Topic D--80,
Application of FASB Statement No. 5 and No. 114 to a Loan
Portfolio (EITF D--80).
Nature and Purpose of the ALLL
Questions #1
May institutions project or forecast changes in facts and
circumstances that arise after the balance sheet date when estimating
the amount of loss under FAS 5 in a group of loans with similar risk
characteristics at the balance sheet date?
Answer:
No. In developing loss measurements for groups of loans with similar
risk characteristics, an institution should consider the impact of
current qualitative or environmental factors that exist as of the
balance sheet date, and should document how those factors were used in
the analysis and how they affect the loss measurements. For any
adjustments to the historical loss rate reflecting current
environmental factors, an institution should support and reasonably
document the amount of its adjustments and how the adjustments reflect
current information, events, circumstances, and conditions.
For example, assume an institution's borrowers depend upon revenues
and personal incomes generated from a local military base. If a public
announcement was made prior to the balance sheet date that the base
would be closed within the next six to eight months, the event of the
impending closure changes the collectibility of, and the estimated
credit losses within, the loan portfolio in the current period.
Therefore, the ALLL level would likely require adjustment based upon
the event of the announcement. As the institution is able to obtain
additional information about its loans to borrowers affected by the
impending military base closure, the estimated credit losses would
likely change over time. The institution should not, however, wait
until the actual closure to estimate the credit losses resulting from
this event.
{{12-29-06 p.5462.07}}
In contrast, suppose there is a rumor circulating that a local
military base may close. However, the institution has not
been able to substantiate the rumor as of the balance sheet date. Since
the rumor is unsubstantiated, it is not an event that would likely
require adjustments to the ALLL level.
Responsibilities of the Board of Directors and Management
Appropriate ALLL Level
Question #2
How should an institution identify loans that should be individually
evaluated for impairment under FAS 114?
Answer:
An institution should apply its normal review procedures when
identifying which loans should be individually evaluated under FAS 114.
Footnote 1 of FAS 114 identifies sources of information that are useful
in identifying loans for individual evaluation as follows:
Sources of information useful in identifying loans for
evaluation . . . include a specific materiality criterion;
regulatory reports of examination; internally generated listings such
as "watch lists," past due reports, overdraft listings, and
listings of loans to insiders; management reports of total loan amounts
by borrower; historical loss experience by type of loan; loan files
lacking current financial data related to borrowers and guarantors;
borrowers experiencing problems such as operating losses, marginal
working capital, inadequate cash flow, or business interruptions; loans
secured by collateral that is not readily marketable or that is
susceptible to deterioration in realizable value; loans to borrowers in
industries or countries experiencing economic instability; and loan
documentation and compliance exception reports.
Large groups of smaller-balance homogeneous loans that are
collectively evaluated for impairment are not included in the scope of
FAS 114. Such groups of loans may include, but are not limited to,
"smaller" commercial loans, credit card loans, residential
mortgages, and consumer installment loans. FAS 114 would apply,
however, if the terms of any of such loans are modified in a troubled
debt restructuring as defined by Statement of Financial Accounting
Standards No. 15, Accounting by Debtors and Creditors for
Troubled Debt Restructuring (FAS 15). Otherwise, the relevant
accounting guidance for these groups of smaller-balance homogeneous
loans is contained in FAS 5.
Many examiners and institutions have sought guidance on how to
quantify "larger" versus "smaller" balance loans in order
to identify which loans should be evaluated for impairment under FAS
114. A single-size test for all loans is impractical because a loan
that may be relatively large for one institution may be relatively
small for another. Deciding whether to individually evaluate a loan is
subjective and requires an institution to consider individual facts and
circumstances along with its normal review procedures in making that
judgment. In addition, the institution should appropriately document
the method and process for identifying loans to be evaluated under FAS
114.
Question #3
If an institution concludes that an individual loan specifically
identified for evaluation is not impaired under FAS 114,
should that loan be included in the assessment of the ALLL under FAS 5?
Answer:
Yes, generally, that loan should be evaluated under FAS 5. If the
specific characteristics of the individually evaluated loan that is not
impaired indicate that it is probable that there would be an incurred
loss in a group of loans with those characteristics, then the loan
should be included in the assessment of the ALLL for that group of
loans under FAS 5. Institutions should measure estimated credit losses
under FAS 114 only for loans individually evaluated and determined to
be impaired.
Under FAS 5, a loss is recognized if characteristics of a loan
indicate that it is probable that a group of similar loans includes
some estimated credit losses even though the loss cannot be identified
to a specific loan. Such a loss would be recognized if it is
probable
{{12-29-06 p.5462.08}}that the loss has been incurred at the date
of the financial statements and the amount of loss can be reasonably
estimated. (EITF D--80, Question 10).
Question #4
If an institution assess an individual loan under FAS 114 and
determines that it is impaired, but it measures the amount of
impairment as zero, may it include that loan in a group of loans
collectively assessed under FAS 5 for estimation of the ALLL?
Answer:
No. For a loan that is impaired, no additional loss recognition is
appropriate under FAS 5 even if the measurement of impairment under FAS
114 results in no allowance. One example would be when the recorded
investment in an impaired loan has been written down to a level where
no allowance is required. (EITF Topic D--80, Question 12)
However, before concluding that an impaired FAS 114 loan needs no
association loss allowance, an institution should determine and
document that its measurement process was appropriate and that it
considered all available and relevant information. For example, for a
collateral-dependent loan, the following factors should be considered
in the measurement of impairment under the fair value of collateral
method: volatility of the fair value of the collateral, timing and
reliability of the appraisal or other valuation, timing of the
institution's or third party's inspection of the collateral,
confidence in the institution's lien on the collateral, historical
losses on similar loans, and other factors as appropriate for the loan
type. For further information, refer to the banking agencies' 2001
Policy Statement on the Allowance for Loan and Lease Losses
Methodologies and Documentation for Banks and Savings Institutions
(2001 Policy Statement), Q&A #3, which is consistent with the
Securities and Exchange Commission's Staff Accounting Bulletin No.
102, Selected Loan Loss Allowance Methodology and Documentation
Issues (SAB 102), Question 7. For credit unions, see the NCUA's
May 2002 Interpretive Ruling and Policy Statement 02--3,
Allowance For Loan and Lease Losses Methodologies and
Documentation for Federally-Insured Credit Unions (NCUA's 2002
IRPS), Q&A #3.
Question #5
Is the practice of "layering" an institution's loan loss
allowance appropriate?
Answer:
No. Layering is the inappropriate practice of recording in the ALLL
more than one amount for the same estimated credit loss. When measuring
and documenting estimated credit losses, institutions should take steps
to prevent the layering of loan loss allowances. One situation in which
layering inappropriately occurs is when an institution includes a loan
in one group of loans, determines its best estimate of loss for that
loan group (after taking into account all appropriate environmental
factors, conditions, and events), and then includes the loan in another
group, which receives an additional ALLL amount. Another example of
inappropriate layering occurs when an allowance has been measured for a
loan under FAS 114 after the loan has been individually evaluated for
impairment and determined to be impaired, but the loan is then included
in a group of loans with similar risk characteristics for which all
ALLL is estimated under FAS 5. The allowance provided for a specific
individually impaired loan under FAS 114 must not be supplemented by an
additional allowance under FAS 5. (2001 Policy Statement, Appendix B;
and NCUA's 2002 IRPS, p. 37450).
Question #6
What documentation should an institution maintain to support its
measurement of impairment on an individually impaired loan under FAS
114?
Answer:
The 2001 Policy Statement and the NCUA's 2002 IRPS discuss the
supporting documentation needed. In general, the institution should
document the analysis that resulted in the impairment decision for each
loan and the determination of the impairment measurement method used.
Additional documentation would depend on which of the three impairment
measurement method is used. For example, for collateral-dependent loans
for which an institution must use the fair value of collateral method,
the institution should
{{12-29-06 p.5462.09}}document: (1) how fair value was determined
including the use of appraisals, valuation assumptions, and
calculations; (2) the supporting rationale for adjustments to appraised
values, if any; (3) the determination of costs to sell, if applicable;
and (4) appraisal quality and the expertise and independence of the
appraiser.
Question #7
How should an institution evaluate and account for impairment on
loans that are within the scope of FAS 15 as "troubled debt
restructuring"?
Answer:
Loans that are within the scope of FAS 15 as "troubled debt
restructurings" should be evaluated for impairment under FAS 114.
This includes loans that were originally not subject to FAS 114 prior
to the restructuring, such as individual loans that were included in a
large group of smaller-balance homogeneous loans collectively evaluated
for impairment. A loan is impaired when, based on current information
and events, it is probable that an institution will be unable to
collect all amounts due according to the contractual terms of the loan
agreement. Usually, a restructured troubled loan that had been
individually evaluated under FAS 114 would already have been identified
as impaired because the borrower's financial difficulties existed
before the formal restructuring. For a restructured troubled loan
all amounts due according to the contractual terms means the
contractual terms specified by the original loan agreement, not the
contractual terms specified by the restructuring agreement. Therefore,
if impairment is measured using an estimate of the expected future case
flows, the interest rate used to calculate the present value of those
cash flows is based on the original effective interest rate on the loan
(the original contractual interest rate adjusted for any net deferred
loan fees or cost or any premium or discount existing at the
origination or acquisition of the loan) and not the rate specified in
the restructuring agreement.
Question #8
If a borrower is current under the modified terms of a restructured
troubled loan, how should the loan be reported in the bank Reports of
Condition and Income (Call Report), the Thrift Financial Report (TFR)
and the NCUA 5300 Call Report (5300)?
Answer:
Call Report
For regulatory reporting purposes on the bank Call Report, a loan
that has been formally restructured so as to be reasonably assured of
repayment and of performance according to its modified terms need not
be maintained in nonaccrual status, provided the restructuring and any
charge-off taken on the loan are supported by a current, well
documented credit evaluation of the borrower's financial condition and
prospects for repayment under the revised terms. Otherwise, the
restructured loan must remain in nonaccrual status.
The evaluation of the borrower's financial condition and prospects
must include consideration of the borrower's sustained historical
repayment performance for a reasonable period prior to the date on
which the loan is returned to accrual status. A sustained period of
repayment performance generally would be a minimum of six months and
would involve payments of cash or cash equivalents. Each loan that has
undergone a troubled debt restructuring (except a loan secured by a 1-4
family residential property and a loan to an individual for household,
family, and other personal expenditures) must be reported as a
restructured loan in Schedule RC-C or Schedule RC-N, as appropriate,
depending on whether the borrower is in compliance with the loan's
modified terms. However, a restructured loan that yields a market rate
and on which the borrower is in compliance with the loan's modified
terms need not continue to be reported as a troubled debt restructuring
in calendar years after the year in which the restructuring took place.
TFR
For regulatory reporting purposes on the TFR, a savings association
may remove a restructured troubled loan from nonaccrual status when it
is (1) reasonably assured of repayment and is performing according to
the modified terms, and (2) the restructured loan is well secured and
collection of principal and interest under the revised terms is
probable.
{{12-29-06 p.5462.10}}To determine probability of collection, the
savings association must consider the borrower's sustained historical
repayment performance for a reasonable period of time. This
determination may take into account performance prior to restructuring
the loan. A sustained period of repayment performance generally would
equal a minimum of six months and would involve payments of cash or
cash equivalents.
Loans that have undergone troubled debt restructurings (TDRs) should
generally be reported as a TDR (on Schedule VA if in compliance with
the restructured terms or on Schedule PD if past due or nonaccrual)
until the loans are paid off. However, a restructured loan that is in
compliance with its modified terms and yields a market rate at the time
of restructuring need not continue to be reported as a TDR beyond the
first year after the restructuring.
5300
For regulatory reporting purposes on the 5300, credit unions should
report troubled debt restructured loans (as defined in GAAP) as
delinquent consistent with the original loan contract terms until the
borrower/member has demonstrated an ability to make timely and
consecutive monthly payments over a six-month period consistent with
the restructured terms. Likewise, such loans may not be returned to
full accrual status until the six-month consecutive payment requirement
is met.
Factors to Consider in the Estimation of Credit Losses
Question #9
If an institution measures impairment based on the present value of
expected future cash flows for FAS 114 purposes, what factors should be
considered when estimating the cash flows?
Answer:
An institution should consider all available information reflecting past
events and current conditions when developing its estimate of expected
future cash flows. All available information would include a best
estimate of future cash flows taking into account existing
"environmental" factors (e.g., existing industry, geographical,
economic, and political factors) that are relevant to the
collectibility of that loan (EITF D--80, Question 16)
Question #10
When an institution writes down an individually impaired loan to the
appraised value of the collateral because that portion of the loan has
been identified as uncollectible, and therefore is deemed to be a
confirmed loss, will there be a loan loss allowance under FAS 114
associated with the remaining recorded investment in the loan?
Answer:
Generally, yes. Typically, the most recent appraised value will
differ from fair value (less costs to sell) as of the balance sheet
date. For an impaired collateral-dependent loan, the agencies generally
require an institution to charge off any portion of the recorded
investment in excess of the fair value of the collateral that can be
identified as uncollectible. Estimated costs to sell also must be
considered in the measure of the ALLL under FAS 114 if these costs are
expected to reduce the cash flows available to satisfy the loan.
Although an institution should consider the appraised value of the
collateral as the starting point for determining its fair value, the
institution should also consider other factors and events in the
environment that may affect the current fair value of the collateral
since the appraisal was performed. The institution's experience with
whether the appraised values of impaired collateral-dependent loans are
actually realized should also be taken into account. In addition, the
timing of when the cash flows are expected to be received from the
underlying collateral could affect the fair value of the collateral if
the timing was not contemplated in the appraisal. This generally
results in the appraised value of the collateral being greater than the
institution's estimate of the collateral's fair value (less costs to
sell).
As a consequence, if the institution's allowance for the impaired
collateral-dependent loan under FAS 114 is based on fair value (less
costs to sell), but its charge-off is based on the
{{12-29-06 p.5462.11}}higher appraised value, the remaining
recorded investment in the loan after the charge-off will have a loan
loss allowance for the amount by which the estimated fair value of the
collateral (less costs to sell) is less than its appraised value.
Appendix B of the 2001 Policy Statement and Appendix A of the
NCUA's 2002 IRPS provide the following illustration of this concept:
An institution determined that a collateral-dependent loan,
which it identified for evaluation, was impaired. In accordance with
FAS 114, the institution established an ALLL for the amount that the
recorded investment in the loan exceeded the fair value of the
underlying collateral, less costs to sell. Consistent with relevant
regulatory guidance, the institution classified as "Loss" the
portion of the recorded investment deemed to be the confirmed loss, and
classified the remaining recorded investment as "Substandard."
For this loan, the amount classified "Loss" was less than the
impairment amount (as determined under FAS 114). The institution
charged off the "Loss" portion of the loan. After the charge-off,
the portion of the ALLL related to this "Substandard" loan (1)
reflects an appropriate measure of impairment under FAS 114, and (2) is
included in the aggregate FAS 114 ALLL for all loans that were
identified for evaluation and individually considered impaired. The
aggregate FAS 114 ALLL is included in the institution's overall ALLL.
Measurement of Estimated Credit Losses
Question #11
Under the banking agencies' regulatory classification guidelines,
"Substandard" assets are defined as assets that are inadequately
protected by the current sound worth and paying capacity of the obligor
or of the collateral pledged, if any. Assets so classified must have a
well-defined weakness or weaknesses that jeopardize the liquidation of
the debt. They are characterized by the distinct possibility that the
institution will sustain some loss if the deficiencies are not
corrected. How should an allowance be established for a commercial loan
adversely classified as "Substandard" based on this regulatory
classification framework?
Answer:
Given the definition, a "Substandard" loan that is
individually evaluated for impairment under FAS 114 (and that is not
the remaining recorded investment in a loan that has been partially
charged off) would not automatically meet the definition of impaired.
However, if a "Substandard" loan is significantly past due or is
in nonaccrual status, the borrower's performance and condition provide
evidence that the loan is impaired, i.e., that it is probable that the
institution will be unable to collect all amounts due according to the
contractual terms of the loan agreement. An individually evaluated
"Substandard" loan that is determined to be impaired must have
its allowance measured in accordance with FAS 114.
For "Substandard" loans that are not determined to be impaired
in accordance with FAS 114, experience has shown that there are
probable incurred losses associated with a group of "Substandard"
loans that must be provided for in the ALLL under FAS 5. Many
institutions maintain records of their historical loss experience for
loans that fall into the regulatory "Substandard" category. A
group analysis based on historical experience, adjusted for qualitative
or environmental factors, is useful for such credits.
For an institution whose groups of loans with similar risk
characteristics include both loans classified "Substandard" (and
not determined to be impaired) and loans that are not adversely
classified, the institution should separately track and analyze the
"Substandard" loans in the group. This analysis will aid in
determining whether the volume and severity of these adversely
classified loans differs from the volume and severity of such loans
during the period over which the institution's historical loss
experience was developed and, if so, the extent and direction of a
qualitative adjustment to the historical loss experience used to
estimate the ALLL for the group of loans under FAS 5.
{{12-29-06 p.5462.12}}
Question #12
Is it appropriate for banks and savings associations to estimate an
allowance for "pass" loans and for credit loans to estimate an
allowance for loans that do not raise supervisory concern? (The banking
agencies define "pass" loans as loans that are not adversely
classified as "Substandard," "Doubtful," or "Loss"
nor designated as "Special Mention.")
Answer:
Yes. To determine an appropriate level for the allowance, an
institution must analyze the entire loan and lease portfolio for
probable losses that have already been incurred that can be reasonably
estimated. A loan designated as "pass" or not raising supervisory
concern generally would not be found to be impaired if it were
individually evaluated for impairment under FAS 114. If the specific
characteristics of such a loan indicate that it is probable that there
would be an incurred loss in a group of loans with those
characteristics, then the loan should be included in the assessment of
the ALLL for that group of loans under FAS 5. Under FAS 5, the
determination of probable incurred losses that can be reasonably
estimated may be considered for individual loans or in relation to
groups of similar types of loans. This determination should be made on
a group basis even though the particular loans that are uncollectible
in the group may not be individually identifiable. Accordingly, the
ALLL for a group of loans with similar risk characteristics, which
includes loans designated as "pass" or not raising supervisory
concern, should be measured under FAS 5.
As noted in the 2006 Policy Statement, some institutions remove
loans that become adversely classified or graded from a group of
"pass" loans with similar risk characteristics in order to
evaluate the removed loans individually under FAS 114 (if deemed
impaired) or collectively in a group of adversely classified or graded
loans with similar risk characteristics under FAS 5. In this situation,
the net charge-off experience on the adversely classified or graded
loans that have been removed from the group of "pass" loans
should be included in the historical loss rates for that group of
loans. Even though the net charge-off experience on the adversely
classified or graded loans is included in the estimation of the
historical loss rates that will be applied to the group "pass"
loans, the adversely classified or graded loans themselves are no
longer included in that group for purposes of estimating credit losses
on the group.
Question #13
May an institution include amounts designated as "unallocated"
in its ALLL?
Answer:
Yes, the ALLL may include an amount labeled as "unallocated"
as long as it reflects estimated credit losses determined in accordance
with GAAP and is properly supported.
The term "unallocated" is not defined in GAAP, but is used in
practice with various meanings. For example, some institutions refer to
the ALLL resulting from the adjustments they make to their historical
loss rates for groups of loans for qualitative or environmental factors
as "unallocated." Others believe that the ALLL resulting from
those adjustments is an element of the "allocated" ALLL under FAS
5. Still other institutions believe "unallocated" refers to any
ALLL amounts that are not attributable to or were not measured on any
particular groups of loans. Economic developments that surface between
the time management estimates credit losses and the date of the
financial statements, as well as certain other factors such as natural
disasters that occur before the date of the financial statements, are
examples of environmental factors that may cause losses that apply to
the portfolio as a whole and are difficult to attribute to individual
impaired loans or to specific groups of loans and, as a consequence,
result in an "unallocated" amount.
An "unallocated" portion of the ALLL may or may not be
consistent with GAAP. If an institution includes an amount labeled
"unallocated" within its ALLL that reflects an amount of
estimated credit losses that is appropriately supported and documented,
that amount would be acceptable as part of management's best estimate
of credit losses. The label "unallocated," by itself, does not
indicate whether an amount so labeled is acceptable or unacceptable
within management's estimate of credit losses. Rather, it is
management's
{{10-31-07 p.5462.13}}objective evidence, analysis, and
documentation that determine whether an "unallocated" amount is
an acceptable part of the ALLL under GAAP.
Appropriate support for any amount labeled "unallocated"
within the ALLL should include an explanation for each component of the
"unallocated" amount, including how the component has changed
over time based upon changes in the environmental factor that gave rise
to the component. In general, each component of any "unallocated"
portion of the ALLL should fluctuate from period to period in a manner
consistent with the factors giving rise to that component (i.e.,
directional consistency).
Question #14
Is there a specific period of time that should be used when
developing historical experience for groups of loans with similar risk
characteristics for purposes of estimating the FAS 5 portions of the
ALLL?
Answer:
There is no fixed period of time that institutions should use to
determine historical loss experience. During periods of economic
stability in an institution's market, a relatively long period of time
may be appropriate. However, during periods of significant economic
expansion or contraction, the relevance of data that are several years
old may be limited. The period used to develop a historic loss rate
should be long enough to capture sufficient loss data. At some
institutions, the length of time the institution uses varies by
product; high-volume consumer loan products generally use a shorter
time period than more specialized commercial loan products.
An institution should maintain supporting documentation for the
techniques used to develop its loss rates. Such documentation includes
evidence of the average and range of historical loss rates (including
gross charge-offs and recoveries) by common risk characteristics (e.g.,
type of loan, loan grade, and past due status) over the historical
period of time used. At larger institutions, this information is often
further segmented by originating branch office or geographic area. An
institution's supporting documentation should include an analysis of
how the current conditions compare to conditions during the time period
used to develop historical loss rates for each group of loans assessed
under FAS 5. An institution should review the range of historical
losses over the time period it uses, rather than relying solely on the
average historical loss rate over that period, and should identify the
appropriate historical loss rate from within that range to use in
estimating credit losses for the groups of loans. This would ensure
that the appropriate historical experience is captured and is relevant
to the institution's current portfolio of loans.
Question #15
An institution has had very low or zero historical losses in the
past several years. How should the institution take this historical
loss experience into account in calculating its ALLL?
Answer:
Judgment is important in these situations because each
institution's ALLL should be based on an institution-specific analysis
of the loans in its portfolio. Management should perform individual
loan reviews under FAS 114 to determine whether any individually
reviewed loans are impaired and, if impaired, measure its FAS 114
allowance allocations in accordance with that standard.
Individually evaluated loans that are not determined to be impaired
that have specific characteristics that indicate it is probable that
there would be an incurred loss in a group of loans with those
characteristics and all other loans should be evaluated under FAS 5. As
noted in the 2006 Policy Statement, historical loss experience provides
a reasonable starting point for the institution's analysis. However,
historical losses, or even recent trends in losses, are not by
themselves a sufficient basis to determine the appropriate level for
the ALLL. Because the institution's historical loss experience is
minimal, the FAS 5 allowances must be supported based on qualitative or
environmental factors. Management should consider such factors as
changes in lending policies, changes in the trend and volume of past
due and adversely classified or graded loans, changes in local and
national economic
{{10-31-07 p.5462.14}}conditions, and effects of changes in loan
concentrations. This will ensure that the ALLL reflects probable
incurred losses in the current portfolio.
Question #16
How should an institution document and support the qualitative or
environmental factors used to adjust historical loss experience to
reflect current conditions as of the financial statement date?
Answer:
As noted in the 2006 Policy Statement, institutions should support
adjustments to historical loss rates and explain how the adjustments
reflect current information, events, circumstances, and conditions in
the loss measurements. Management should maintain reasonable
documentation to support which factors affected the analysis and the
impact of those factors on the loss measurement. Support and
documentation includes descriptions of each factor, management's
analysis of how each factor has changed over time, which loan groups'
loss rates have been adjusted, the amount by which loss estimates have
been adjusted for changes in conditions, an explanation of how
management estimated the impact, and other available data that supports
the reasonableness of the adjustments. Examples of underlying
supporting evidence could include, but are not limited to, relevant
articles from newspapers and other publications that describe economic
events affecting a particular geographic area, economic reports and
data, and notes from discussions with borrowers.
Management must exercise significant judgment when evaluating the
effect of qualitative factors on the amount of the ALLL because data
may not be reasonably available or directly applicable for management
to determine the precise impact of a factor on the collectibility of
the institution's loan portfolio as of the evaluation date. For
example, the institution may have economic data that shows commercial
real estate vacancy rates have increased in a portion of its lending
area. Management should determine an appropriate adjustment for the
effect of that factor on its current portfolio that may differ from the
adjustment made for the effect of that factor on its loan portfolio in
the past. It is management's responsibility to use its judgment to
determine the best estimate of the impact of that factor and document
its rationale for its best estimate. This rationale should be
reasonable and directionally consistent with changes that have occurred
in that factor based on the underlying supporting evidence previously
discussed.
[Source: FDIC Financial Institution Letter (FIL--105--2006), dated
December 13, 2006]
1 This policy statement applies to all depository institutions
(institutions), except U.S. branches and agencies of foreign banks,
supervised by the Office of the Comptroller of the Currency, the Board
of Governors of the Federal Reserve System, the Federal Deposit
Insurance Corporation, the Office of Thrift Supervision (the
"banking agencies") and to institutions insured and supervised by
the National Credit Union Administration (NCUA) (collectively, the
"agencies"). U.S. branches and agencies of foreign banks continue
to be subject to any separate guidance that has been issued by their
primary supervisory agency. Go Back to Text
2 As discussed more fully in the "Nature and Purpose of the
ALLL" section below, this policy statement and the ALLL generally do
not address loans carried at fair value or loans held for sale. In
addition, this policy statement provides only limited guidance on
"purchased impaired loans." Go Back to Text
3 The 2001 Policy Statement and the 2002 NCUA IRPS are
available on the agencies' Web sites. In addition, the SEC staff
issued parallel guidance in July 2001 in Staff Accounting Bulletin No.
102 -- Selected Loan Loss Allowance Methodology and Documentation
Issues (SAB 102), which has been codified as Topic 6.L. in the
SEC's Codification of Staff Accounting Bulletins. Both SAB 102 and the
Codification are available on the SEC's Web site. Go Back to Text
4 Consistent with the American Institute of Certified Public
Accountants' (AICPA) Statement of Position 01--6, Accounting by
Certain Entities (Including Entities With Trade Receivables) That Lend
to or Finance the Activities of Others, loans and leases held for
investment are those loans and leases that the institution has the
intent and ability to hold for the foreseeable future or until maturity
or payoff. Go Back to Text
5 Refer to the "Interagency Guidance on Certain Loans Held
for Sale" (March 26, 2001) for the appropriate accounting and
reporting treatment for certain loans that are sold directly from the
loan portfolio or transferred to a held-for-sale account. Loans held
for sale are reported at the lower of cost or fair value. Declines in
value occurring after the transfer of a loan to the held-for-sale
portfolio are accounted for as adjustments to a valuation allowance for
held-for-sale loans and not as adjustments to the ALLL. Go Back to Text
6 Credit losses on off-balance sheet credit exposures should
be estimated in accordance with FAS 5. Any allowance for credit losses
on off-balance sheet exposures should be reported on the balance sheet
as an "Other Liability," not as part of the ALLL. Go Back to Text
7 FAS 5 requires the accrual of a loss contingency when
information available prior to the issuance of the financial statements
indicates it is probable that an asset has been impaired at the date of
the financial statements and the amount of loss can be reasonably
estimated. These conditions may be considered in relation to individual
loans or in relation to groups of similar types of loans. If the
conditions are met, accrual should be made even thought the particular
loans that are uncollectible may 7cond't. not be identifiable. Under FAS 114, an individual
loan is impaired when, based on current information and events, it is
probable that a creditor will be unable to collect all amounts due
according to the contractual terms of the loan agreement. It is
implicit in these conditions that it must be probable that one or more
future events will occur confirming the fact of the loss. Thus, under
GAAP, the purpose of the ALLL is not to absorb all of the risk in the
loan portfolio, but to cover probable credit losses that have already
been incurred. Go Back to Text
8 A "purchased impaired loan" is defined as a loan that
an institution has purchased, including a loan acquired in a purchase
business combination, that has evidence of deterioration of credit
quality since its origination and for which it is probable, at the
purchase date, that the institution will be unable to collect all
contractually required payments. When reviewing the appropriateness of
the reported ALLL of an institution with purchased impaired loans,
examiners should consider the credit losses factored into the initial
investment in these loans when determining whether further
deterioration, e.g., decreases in cash flows expected to be collected,
has occurred since the loans were purchased. The agencies' regulatory
reports and disclosures in financial statements may provide useful
information for examiners in reviewing these loans. Refer to the
AICPA's Statement of Position 03--3, Accounting for Certain
Loans or Debt Securities Acquired in a Transfer, for further
guidance on the appropriate accounting. Go Back to Text
9 FAS 114 does not specify how an institution should identify
loans that are to be evaluated for collectibility nor does it specify
how an institution should determine that a loan is impaired. An
institution should apply its normal loan review procedures in making
those judgments. Refer to the FAQs for further guidance. Go Back to Text
10 The effective interest rate on a loan is the rate of return
implicit in the loan (that is, the contractual interest rate adjusted
for any net deferred loan fees or costs and any premium or discount
existing at the origination or acquisition of the loan). Go Back to Text
11 For further information, banks and savings associations
should refer to the Illustration in Appendix B of the 2001 Policy
Statement. Credit unions should refer to the section heading
"Application of GAAP" in the NCUA's 2002 IRPS. Go Back to Text
12 An individually evaluated loan that is determined not to be
impaired under FAS 114 should be evaluated under FAS 5 when specific
characteristics of the loan indicate that it is probable there would be
estimated credit losses in a group of loans with those characteristics.
Refer to the FAQs for further guidance. Go Back to Text
13 As noted in the 2001 Policy Statement and the NCUA's 2002
IRPS, an institution with less complex lending activities and products
may find it more efficient to combine a number of procedures while
continuing to ensure that the institution has a consistent and
appropriate ALLL methodology. Thus, much of the supporting
documentation required for an institution with more complex products or
portfolios may be combined into fewer supporting documents in an
institution with less complex products or portfolios. Go Back to Text
14 Loan review and loan classification or credit grading
systems are discussed in Attachment 1. In addition, banks and savings
associations should refer to the asset quality standards in the
Interagency Guidelines Establishing Standards for Safety and Soundness
adopted by their primary federal regulator, as follows: for national
banks, Appendix A to Part 30; for state member banks, Appendix D--1 to
Part 208; for state nonmember banks, Appendix A to Part 364; and for
savings associations, Appendix A to Part 570. Go Back to Text
15 A component of the ALLL that is labeled "unallocated"
is appropriate when it reflects estimated credit losses determined in
accordance with GAAP and is properly supported and documented. Go Back to Text
16 As previously noted, the use of the fair value of
collateral method is required for an individually evaluated loan that
is impaired if the loan is collateral dependent. Go Back to Text
17 See footnote 12. Go Back to Text
18 Credit loss and recovery experience may vary significantly
depending upon the stage of the business cycle. For example, an over
reliance on credit loss experience during a period of economic growth
will not result in realistic estimates of credit losses during a period
of economic downturn. Go Back to Text
19 For banks and savings associations, adversely classified or
graded loans are loans rated "Substandard" (or its equivalent) or
worse under the institution's loan classification system. For credit
unions, adversely graded loans are loans included in the more severely
graded categories under the institution's credit grading system, i.e.,
those loans that tend to be included in the credit union's "watch
lists." Go Back to Text
20 Annual charge-off rates are calculated over a specified
time period (e.g., three years or five years), which can vary based on
a number of factors including the relevance of past periods'
experience to the current period or point in the credit cycle. Also,
some institutions remove loans that become adversely classified or
graded from a group of nonclassified or nongraded loans with similar
risk characteristics in order to evaluate the removed loans
individually under FAS 114 (if deemed impaired) or collectively in a
group of adversely classified or graded loans with similar risk
characteristics under FAS 5. In this situation, the net charge-off
experience on the adversely classified or graded loans that have been
removed from the group of nonclassified or nongraded loans should be
included in the historical loss rates for that group of loans. Even
though the net charge-off experience on adversely classified or graded
loans is included in the estimation of the historical loss rates that
will be applied to the group of nonclassified or nongraded loans, the
adversely classified or graded loans themselves are no longer included
in that group for purposes of estimating credit losses on the group. Go Back to Text
21 An overall adjustment to a portion of the ALLL that is not
attributed to specific segments of the loan portfolio is often labeled
"unallocated." Regardless of what a component of the ALLL is
labeled, it is appropriate when it reflects estimated credit losses
determined in accordance with GAAP and is properly supported. Go Back to Text
22 As noted in FAS 114, some individually impaired loans have
risk characteristics that are unique to an individual borrower and the
institution will apply the measurement methods on a loan-by-loan basis.
However, some impaired loans may have risk characteristics in common
with other impaired loans. An institution may aggregate those loans and
may use historical statistics, such as average recovery period and
average amount recovered, along with a composite effective interest
rate as a means of measuring impairment of those loans. Go Back to Text
23 It is inappropriate to use a "standard percentage" as
the sole determinant for the amount to be reported as the ALLL on the
balance sheet. Moreover, an institution should not simply default to a
peer ratio or a "standard percentage" after determining an
appropriate level of ALLL under its methodology. However, there may be
circumstances when an institution's ALLL methodology and credit risk
identification systems are not reliable. Absent reliable data of its
own, management may seek data that could be used as a short-term proxy
for the unavailable information (e.g., an industry average loss rate
for loans with similar risk characteristics). This is only appropriate
as a short-term remedy until the institution creates a viable system
for estimating credit losses within its loan portfolio. Go Back to Text
24 Refer to the agencies' regulatory reporting instructions
for the Call Report, TFR, or 5300 for further guidance on placing a
loan in nonaccrual status. Go Back to Text
25 In an examiner's review of an institution's loan review
system, the examiner's loan classifications or credit grades may
differ from those of the institution's loan review system. If the
examiner's evaluation of these differences indicates problems with the
loan review system, especially when the loan classification or credit
grades assigned by the institution are more liberal than those assigned
by the examiner, the institution would be expected to make appropriate
adjustments to the assignment of its loan classifications or credit
grades to the loan portfolio and to its estimated credit losses.
Furthermore, the institution would be expected to improve its loan
review system. (Attachment 1 discusses effective loan review
systems.) Go Back to Text
26 As noted previously, accrued interest and fees on loans
that have been reported as part of the respective loan balances on the
institution's balance sheet should be evaluated for estimated credit
losses. The accrual of the interest and fee income should also be
considered. Refer to GAAP and the agencies' regulatory reporting
instructions for further guidance on income recognition. Go Back to Text
27 The loan review function is not intended to be performed by
an institution's internal audit function. However, as discussed in the
banking agencies' March 2003 Interagency Policy Statement on the
Internal Audit Function and its Outsourcing, some institutions
seek to coordinate the internal audit function with several risk
monitoring functions such as loan review. The policy statement notes
that coordination of loan review with the internal audit function can
facilitate the reporting of material risk and control issues to the
audit committee, increase the overall effectiveness of these monitoring
functions, better utilize available resources, and enhance the
institution's ability to comprehensively manage risk. However, the
internal audit function should maintain the ability to independently
audit other risk monitoring functions, including loan review, without
impairing its independence with respect to these other functions. Go Back to Text
28 A bank or savings association may have a loan
classification or credit grading system that differs from the framework
used by the banking agencies. However, each institution that maintains
a loan classification or credit grading system that differs from the
banking agencies' framework should maintain documentation that
translates its system into the framework used by the banking agencies.
This documentation should be sufficient to enable examiners to
reconcile the totals for the various loan classifications or credit
grades under the institution's system to the banking agencies'
categories. Go Back to Text
29 For banks and savings associations, loans that have
potential weaknesses that deserve management's close attention are
designated "Special Mention" loans. Go Back to Text
30 In particular, institutions with large and complex loan
portfolios are encouraged to maintain records of their historical loss
experience for credits in each of the categories in their loan
classification or credit grading framework. For banks and savings
associations, these categories should either be those used by, or
should be categories that can be translated into those used by, the
banking agencies. Go Back to Text
31 Significant credits in this context may or may not be loans
individually evaluated for impairment under FAS 114. Go Back to Text
32See footnote 29. Go Back to Text
33 The board of directors should be informed more frequently
than quarterly when material adverse trends are noted. Go Back to Text
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