In a joint release at the end of 2006, the federal banking regulatory agencies provided a new policy statement on establishing an allowance for loan and lease losses (ALLL) that is consistent with both generally accepted accounting principles (GAAP) and banking supervisory guidance. The new policy statement, issued December 13, 2006, replaces a 1993 policy statement and is intended to address the dilemma faced by banks and thrifts of accurately measuring and reporting the verifiable impairment of their loan portfolio, while preparing in a prudent manner for borrowers’ possible future difficulties. The new policy statement attempts to strike a balance by recognizing and reconfirming the proper role of management judgment, when that judgment is exercised within the bounds of a comprehensive, systematic, and consistently applied program of loan review. The issuance of this policy statement is timely, since it has come at a time when lenders who have enjoyed several years of unusually strong credit conditions across many areas of lending have recently encountered difficulties in some areas, such as subprime mortgage lending. It also should be noted that neither the Securities and Exchange Commission nor the Public Company Accounting Oversight Board joined with the federal banking agencies in issuing the new policy statement. Since determining the ALLL is typically a critical accounting policy for financial services entities, there likely will continue to be tension between safety and soundness on the one hand, and the SEC’s view of GAAP for ALLL on the other.

Identifying Impaired Loans and Measuring Impairment

As the policy statement notes, the principal sources of guidance on accounting for loan impairment are two statements of the Financial Accounting Standards Board (FASB), Financial Accounting Standard No. 5 (FAS 5), “Accounting for Contingencies,” and Financial Accounting Standard No. 114 (FAS 114), “Accounting for Creditors for Impairment of a Loan,” and FASB Emerging Issues Task Force Topic D-80 (EITF D-80), “Application of FASB Statements No. 5, and No. 114 to a Loan Portfolio.” FAS 114 requires that an individual loan be recognized as being impaired when it is probable, based on current information and events, that the creditor will not be able to collect all amounts due according to the contractual terms of the loan, and sets forth three standard measures of impairment. The institution may choose the most appropriate measurement for each loan: present value of expected future cash flows, as discounted based on the loan’s effective interest rate; observable market price; or fair value of collateral (which is the required measure when repayment is expected to be provided solely by underlying collateral).

It is important to note that, while FAS 114 directs how to measure loan impairment, it does not specify how an institution should identify in the first place those loans to be evaluated for collectibility, nor does it specify how an institution should determine that the collection of the loan in full is not likely. The monitoring of loan portfolios, borrowers, and market conditions, as discussed below, is a managerial and supervisory matter, and not solely an accounting matter.

FAS 5 requires that a loss contingency be accrued when an institution can reasonably estimate that an individual loan or a group of similar loans have become impaired during the reporting period for which financial statements are to be issued, provided that the impairment can be reasonably estimated. FAS 5, unlike FAS 114, does not require that individual loans that are uncollectible be identified. 1/ However, if a loan is individually evaluated and determined to be impaired under FAS 114, no further evaluation of that loan under FAS 5 should occur. Conversely, a loan may be determined not to be impaired under FAS 114 yet have characteristics that indicate that a group of loans with that characteristic would probably suffer some credit losses, and such a loan should be included when that group of loans is evaluated under FAS 5.

Comprehensive and Consistent Management Oversight

Management is responsible for maintaining an appropriate ALLL in light of the accounting guidance in FAS 5 and FAS 114 and the banking agencies’ guidance. The federal banking agencies expect an institution to have written policies and procedures that describe how it goes about making the evaluations, classifications, and allocations that are appropriate for the institution given its size, the nature of its lending activities, and the risks embedded in its activities and borrower composition. Its loan review process should be comprehensive, well documented, and consistently applied. It should include accurate and timely loan classification, data recording, and reporting; periodic reevaluation and adjustment of credit loss models to reflect changes in an institution’s loan portfolio and external changes; prompt chargeoffs; and periodic independent review, such as by an internal audit staff, risk management staff, or external auditor. The role of the board of directors is to oversee management’s more significant judgments and estimates, by engaging in the following, at a minimum: annual review of written ALLL policies and procedures; review of the loan review system; review of the estimated credit losses for each reporting period and of the periodic provision for loan and lease losses, actual chargeoffs, and ALLL; and requiring management to validate and, when appropriate, revise the ALLL methodology.

The heart of the loan review process is the estimation of credit losses. Historical loss experience, or recent trends in losses, are an acceptable starting point for a loan review, but they are inadequate alone. An institution also must consider, and document its consideration of, factors that may cause its credit losses to depart from historical experience. Such factors include, at a minimum, changes in the following: an institution’s underwriting, loan terms, loan administration, chargeoff, collection, and recovery practices; economic and business conditions, both cyclical and secular, at a local, regional, national, and international level, as appropriate; 2/ the volume and severity of an institution’s loan classifications; collateral, credit concentrations, and relevant laws and regulations; competition; and the quality of the institution’s loan review system itself. 3/

Exercising Discretion Within Reasonable Limits

As a general rule, the direction of movement in the size of the ALLL should be consistent with any overall change in the loan portfolio, so that, for example, when the credit quality of an institution’s loan portfolio is declining, the ALLL as a percentage of the portfolio should be increasing. Stated otherwise, if an institution’s loan loss provision and the size of its ALLL are counter-cyclical to its credit quality trends, then the ALLL will be reviewed closely and critically by banking examiners, and, for publicly held institutions, the SEC, to be sure that the ALLL is not being used to manage earnings results rather than to reflect the institution’s financial condition. Subject to this caution, it is possible for an institution to make adjustments to its ALLL that are not attributed to any specific segment of its loan portfolio, but are unallocated, provided that the adjustments are properly supported by the written record and reflect current credit losses determined in accordance with GAAP. However, general uncertainty by management about the effect of future events or about the volatility of the loan portfolio should be addressed by maintaining higher equity capital and not by arbitrarily increasing the ALLL.

The policy statement includes the observation that an institution’s ability to estimate its credit losses should improve over time. Therefore, the policy statement advises, when management has satisfied the requirements above with regard to loan review policies, procedures, recordkeeping, reporting, and monitoring, examiners in turn should generally accept management’s estimates of credit losses, and not seek adjustments to the ALLL. In other words, when management’s procedures comply with supervisory guidelines, and have been found in the past to be generally sound, a prudent or conservative estimate by management of credit losses, within a reasonable range of estimated losses, is acceptable.

Conclusion

While the new policy statement includes technical enhancements to previous guidance, it makes clear that estimating loan and lease losses is not a precise science. It suggests that the focus of examiners should be on the use by banks and thrifts of proper methodologies and their setting of reasonable ranges in which their ALLL may fall. The precision that accountants and auditors may desire is not always attainable, and the goal of precision should not require banks and thrifts to default to a lower ALLL whenever there is uncertainty. On the other hand, the concerns of accountants and auditors have not been eliminated. In particular, since the SEC and the PCAOB did not join with the federal banking agencies in issuing the new policy statement, professional judgments about ALLL will still differ. It is hoped that the policy statement will provide bank and thrift management with the benefit of the doubt when that occurs.