Calculating the Allowance for Loan and Lease Losses

This excerpt from Joe May's June 1991 article outlines steps a bank can take to analyze and determine a reserve level commensurate with the asset quality of its portfolio.

Banking circular 201 [published by the OCC in 1992 and revised in 1993] addresses the adequacy for allowance of loan and lease losses. The object of this publication is to better address how asset quality and reserves are linked. No longer can reserves be used as a vehicle to balance earnings. Likewise, it is unsatisfactory to set aside reserves on classified assets (substandard and doubtful) with the balance of reserves nebulously accounted for as unallocated.

Bankers are expected to complete a detailed reserve analysis by type of portfolio: consumer loans, real estate loans, commercial loans, and international loans. In addition, specific allocations determined by analysis of the larger classified credits also will have to be made. The goal of this analysis is to develop a rationale for supporting reserves, which are expected to reach the level necessary to support the inherent loss in the portfolio.

Lack of a definition of inherent loss. One major problem in making these determinations is the lack of a definition of what constitutes inherent loss. Not only has the OCC been nonspecific in defining this critical term, but other interested parties, such as the Securities and Exchange Commission through its Release No. 28 and the Financial Accounting Standards Board through its Statement No. 5, have added to the confusion. They have narrower and different interpretations as to what constitutes an inherent loss. Thus, bankers continue to lack an authoritarian source on which to rely for a clear directive on the expectations for reserves.

The IRS. Moreover, yet another government agency has had a significant influence in bank reserve determinations. The Internal Revenue Service continually challenges the deductibility of loan loss provisions, which are used to build reserves. Its goals seem almost diametrically opposed to those of the OCC.

Steps to Determine Proper Levels

Despite this lack of clear direction, there are steps that bankers can take to analyze and determine proper reserve levels in relation to asset quality.

To understand the process I recommend, it is appropriate to have the same level of interpretation regarding the life cycle of a credit portfolio, Each credit product portfolio enjoys a unique credit risk profile, which graphically resembles a product's life cycle. It is important to recognize the uniqueness of each of these credit risk profiles--that is, residential mortgages differ considerably from credit cards, which, in turn, differ appreciably from G&I loans.

Key premise. The key to the life-cycle concept is that the loss experience varies by product, based on not only the underwriting and administration of that product's portfolio but, just as important, the age of credits in the portfolio.

Business life cycles. The loss experience in most portfolios during the initial period is nominal. This period is referred to as Phase I: too new to fail. During the ensuing period, or Phase II, losses often rise to peak levels. This is referred to as the high-loss period. Thereafter, we deal with a seasoned portfolio in which losses typically diminish to stable, predictable levels. This last period is Phase III: the mature, stabilizedloss period.

Residential mortgage pools. As noted earlier, each credit product portfolio is unique in terms of both degree of loss and duration of each of its phases, or life cycle.

Perhaps the easiest illustration is residential mortgages. Defaults in the first year are nominal. Losses in years one through five represent the greatest exposure. Thereafter, losses tend to be lower and manageable. Because of this predictable loss pattern, mortgages can be packaged easily into pools of loans for resale and securitization. This package is done today without recourse, in most instances.

Accordingly, the security underwriters and the trustees for these pools of mortgages establish reserves using the aforementioned credit risk product portfolio life cycle. The most important ingredient factored into this determination, other than actual losses anticipated, is the provisioning over the life of the pool expensed against the interest income earned to help replenish the reserves. Figure 1 provides a simplified depiction.

Reserves need not be established at the beginning to cover all the losses expected during the life of this portfolio. Provisions can be made over time to sustain the reserve at levels necessary to meet anticipated losses, which may vary due to changes in the economy and administration.

The underwriting and securitization process. The underwriting and securitization process, which includes the reserving mechanism, is done routinely, not only for residential mortgages as noted but also for credit cards and installment loans. This same technique applies to every loan portfolio.

The process is more difficult when applied to commercial loans, primarily because larger individual transactions create a higher standard deviation for losses than those that are statistically forecast. In lay terms, the process applied to commercial loans is not as readily predictable and, as such, requires greater reserve levels to offset the volatility in the estimating process.

If an institution has the sophistication necessary to analyze each credit product portfolio effectively, including its loss experience, underwriting, administration, and volatility within the economy, then it should be possible to determine the proper loan loss provisioning necessary to sustain adequate reserves in accordance with the above analysis.

Unfortunately, experience has shown that most bankers lack sufficient management information system capabilities to complete a satisfactory analysis as described. Accordingly, an alternative approach must be considered.

Paralleling the regulators' approach. In this regard, my bank has tried to risk-rate all the credits on its books, both consumer and commercial. Our rating process has been designed to parallel the regulators' approach, specifically, identifying other loans especially mentioned (OLEM), substandard, doubtful, and loss. A sample risk-rating system is presented in Figure 2.

Loss experience by major product category. The next step is to determine the historical loss experience by major product category, such as C&L, real estate, and consumer loans. Using the risk ratings for each of these products, set the reserve for standard credit risk rated 3 or 4 to approximate the historical loss experience (five-year average net charge-off). Then, spread out the reserve percent allocation. Lower reserves are required for more favorably risk-rated loans and higher reserves for less favorably rated credits, as illustrated in Figure 3.

Appropriate reserve ranges. Next, test the accuracy of the risk rating and the reserve allocation by analyzing the larger criticized loans. Specifically, determine the appropriate reserve range for each criticized asset. If this process is done properly, risk-rated 5 credits should be at least two years away from a possible loss scenario; a risk-rated 6 credit could sustain a loss in a 12-to 18-month timeframe; and a risk-rated 7 credit could expect losses, absent positive development, in the next six months.

Summary

Bear in mind that this is a dynamic process that requires adjustments on an ongoing basis. These adjustments will relate to changes in underwriting standards, administrative processes, and the economic environment.

An institution's actual allowance for loan and lease losses should equal the sum of the portfolio reserve calculations using the approach outlined herein. The reserve for each portfolio is determined by multiplying the dollar exposure under each risk rating by the reserve percent allocations.

Finally, to pass examinations, this entire process must be thoroughly documented and updated on at least a quarterly basis. The written documentation of this entire process cannot be overemphasized.

From the Author...

Since the original publication of this article in 1991, most banks have expanded their risk-rating matrix to 10 or more grades. The migration analysis has been refined to determine the risk of default plus the loss in the event of a default by product and risk rating. Unlike the table in the original article, reserves are set aside even for the highest-quality assets.

Securitization of assets (mortgages, credit cards, etc.) without recourse to the originating party has helped refine the migration analysis of loans from inception to payment. Conforming residential mortgages are routinely securitized with 2-3 basis points of each payment allocated to the reserve for loan losses.

Joseph May, June 2001

Figure 1

Life Cycles for Mortgage Pools


                  Start  Phase I  Phase II  Phase III  End
                          (New)   (Risky)   (Mature)

Reserve begining   $20     $20      $40        $10
Provision            0     +30      +25        +20
Losses               0     -10      -55        -10
Reserve ending     $20     $40      $10        $20     $20
Figure 2

Sample Risk-Rating System


Risk Rated 1  Cash secured
Risk Rated 2  Investment grade (A)
Risk Rated 3  Standard unsecured/pass credit score
Risk Rated 4  Standard secured/pass credit score
Risk Rated 5  OLEM/30 days' past due
Risk Rated 6  Substandard/60 days past due
Risk Rated 7  Doubtful/90 days past due
Risk Rated 8  Loss
Figure 3

The Allocation of Loan Reserves over Risk Ratings


Reserve      100%
             50%                           +
             20%                        +
             5%                      +
             0.5%                 +
             0%          +  +  +

Risk Rating        0  1  2  3  4  5  6  7  8

COPYRIGHT 2001 The Risk Management Association
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