Historical Loss Rates

1/7/2010

By Joseph M. Press, CPA, CFE

While financial institutions continue the never-ending task revising and refining their processes for determining an appropriate level for the Allowance for Loan and Lease Losses (ALLL), our firm has noted an area of concern that is often the topic of regulatory comment - historical loss rates.

For most institutions, historical loss experience is the starting point in determining the reserve for unimpaired loans. Normally, an institution would 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. However, in developing the historical loss rates, the question arises, "Is there a specific period of time that should be used?"

Regulatory guidance specifically states that 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. Ideally, current conditions should be comparable to conditions during the time period used to develop the historical loss rates.

In addition, 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.

Determining appropriate historical loss rates is not just a mathematical exercise. It is an integral part of the overall ALLL analysis and should reflect both the institution's actual experience and management's sound judgment.

This article reflects guidance set forth in the Interagency Questions and Answers on Accounting for Loan and Lease Losses issued December 13, 2006, which would serve as a helpful resource for those tasked with developing or reviewing an institution's ALLL analysis.