Determining Proper Reserve Levels Requires Consistency

3/17/2011

By Dan McDonald

To determine an appropriate allowance for loan and lease losses (ALLL), institutions must remain consistent over time during periods of economic stability and during periods of significant contraction or expansion. An institution may choose the appropriate ASC 310 (formerly FAS 114) measurement method on a loan-by-loan basis for an individually impaired loan, except for an impaired collateral-dependent loan. All other loans, including individually evaluated loans determined not to be impaired under ASC 310, should be included in a group of loans that is evaluated for impairment under ASC 450 (formerly FAS 5) method.

There are steps that bankers can take to analyze and determine proper reserve levels in relation to asset quality. Bankers are reminded that the level of the reserve, and the methodology determining the level, should be fluid and be directionally consistent, increasing during more difficult times and decreasing during better economic times.

ASC 450

For loans evaluated on a group basis under ASC 450, management should segment the loan portfolio by identifying risk characteristics that are common to groups of loans. ASC 450 allowances must be supported based on qualitative or environmental factors. Management should consider such factors:

• Historical Losses (1) – usually no more than a two years average
• General categories (2)
  • National and local economy
  • Delinquencies and non-accruals
  • Trends in volume and terms of loans
  • Changes in underwriting, policies
  • Experience and depth of lending management & Staff
  • Concentrations of credit
  • Independent loan review results
  • Overall problem loan levels

It is important to note management should maintain reasonable documentation to support which factors affected the analysis and the impact of those factors on the loss measurement.