AUDITING YOUR
ALLOWANCE FOR
LOAN LOSSES
Presentation to the AIBA on September 19, 2013
Chris B. Harris
Managing Director
ICS Consulting Partners
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Outline of Presentation
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Interagency Policy on ALLL
Audit Program Objective
Best practice ALLL audit program
Key documents to be aware of
Reviewing a loan file to determine ALLL
Root causes of errors in ALLL Process
WAR Stories
References to follow for ALLL
Sample Audit Findings
ALLL Policy/Methodology for determining ALLL
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Interagency Policy /Allowance for Loan Losses
“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 loan loss provision. 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.”
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Audit Program Objective
To perform an audit of the Allowance for Loan
and Lease Losses to ensure the adequacy and
effectiveness of the internal controls in
accordance with GAAP and regulatory
guidelines and the Bank’s policies.
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Best Practice ALLL Audit Program
Part 1 - Determine adequacy of Policies and Procedures
1.
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3.
Evaluate Policies and Procedures to determine whether they
provide the basis for an effective internal control system over
the function and to determine if management, consistent with
its duties and responsibilities, has established procedures for
governing the ALLL.
Does the Bank have adequate data capture and reporting
systems to supply the information necessary to support and
document its estimate of an appropriate ALLL?
• Prior history of charge-offs and reserves.
• Loan reviews
• Appraisals
• Minutes
• Supervisory Loan to Value Report
Does the Bank periodically validate the ALLL methodology?
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Best Practice ALLL Audit Program
Part Two - Determine the adequacy of your ALLL’s Control Environment
1.
2.
Is there adequate oversight by the Board of Directors of
management’s judgments and estimates used in determining the
ALLL?
Are the ALLL policies and procedures reviewed as least annually for:
• Discussions relating to the Bank’s quantity of risk, risk
management, and responsiveness to internal and external factors
affecting the level of credit risk.
• Reviewing management’s loan review system to ensure that it
will identify, monitor, and address asset quality problems in an
accurate and timely manner.
• Reviewing management’s assessment and justification for the
amounts estimated and reported each period for the Provision
for Loan and Lease Losses and ALLL.
• Reviewing management’s procedures to periodically validate, and
when appropriate, revise the ALLL methodology.
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Best Practice ALLL Audit Program
Part Two - Determine the adequacy of your ALLL’s Control Environment
3.
4.
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Assess if there is an effective allowance evaluation process by:
• Obtaining a description of the process used by management to
determine if an appropriate level of the allowance has been
recorded along with the supporting documentation for the most
recent evaluation.
• Review and perform the following to determine if the process is
sound, based on reliable information, and well documented.
• Review the written description of the process and methodology
used by management to determine the adequacy of the
allowance.
Review management’s assumptions, valuations and judgments for
reasonableness and ascertain all information is properly supported
and documented.
Determine whether management has considered historical loss
experience for each group of loans with similar characteristics as well
as qualitative and environmental factors that are likely
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Best Practice ALLL Audit Program
Part Two - Determine the adequacy of your ALLL’s Control Environment
to cause estimated credit losses to differ from historical loss experience
(examples are included in the Interagency Statement)
6. Determine whether management has implemented ASC #450 (FASB
105) for when measuring estimated credit losses for groups of loans
with similar characteristics.
7. Determine whether management has implemented ASC #310 (FASB
114) for individually impaired loans. An “Impaired Loan” is a loan
where, in management’s opinion, there has been a deterioration of
credit quality to the extent that the Bank no longer has reasonable
assurance as to the timely collection of the full amount of principal
and interest.
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Best Practice ALLL Audit Program
Part Two - Determine the adequacy of your ALLL’s Control Environment
8.
Determine the rationale of the ALLL methodology that is used for
determining the amount of loan loss provision. Determine that
the methodology considers all key factors, including loan review
ratings and past due status.
9. Determine whether the Bank performs a peer group (Uniform
Bank Performance Report) analysis of other banks of its size and
complexity. Determine if processes relating to loan charge-offs are
adequate.
10. Ensure the accuracy of subsidiary records, security of notes,
appropriate review and approval, and effective collection efforts.
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Part Three - Other Testing Considerations
1.
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Evaluate the timeliness and effectiveness of corrective action taken
by Management in response to prior regulatory reports of
examination; internal/external audits; and, and loan reviews.
Determine the adequacy of loan review process; review prior reports
and evaluate findings pertaining to “Downgrades.”
Determine if there is a process in place to include the most recent
loan review write-up in the loan file.
Determine if there is a process in place to ensure that ratings
downgrades noted in recent loan reviews and/or regulatory
examinations are input into the accounting system as revise ratings
may impact the ALLL calculation.
Is there a report of disagreements between loan review and
management of loan ratings?
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Appendix 1 - Key Documents To Be Aware Of
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Formal Agreements and/or Matters Requiring Attention.
Credit Risk Management Strategy.
Credit Risk Dashboard from their ERM Program.
Minutes/documentation
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Troubled/Restructured/Nonperforming Loan Committee.
Impaired Loans that are Collateral Dependent.
Regulatory examination reports and resulting mandates.
Results of stress testing the portfolio.
Listing of Troubled Debt Restructures and the accounting treatment
for activity.
Loan Underwriting Exception Report of Missing Documents.
Loan Review Reports including downgrades/document exceptions.
Results of Global Cash Flow Analysis.
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Appendix 2 – How you review a file and determine reserve coverage.
• Select a file on a regularly scheduled basis.
• Determine if loan is current or delinquent
• Determine whether financial statements and appraisals are up to
date.
• Evaluate/determine cash flow from financials.
• Determine market value of collateral.
• Determine if impaired; an “Impaired Loan” is a loan where, in
management’s opinion, there has been a deterioration of credit
quality to the extent that the Bank no longer has reasonable
assurance as to the timely collection of the full amount of
principal and interest.
• Determine if Troubled Debt Restructure; process by which an
institutional lender (such as a bank) modifies or relaxes the terms
of a loan agreement to minimize the eventual loss by
accommodating a borrower who is financially incapable of
meeting them.
• Determine exposure to the Bank.
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Appendix 3 - Root Causes of Errors in the ALLL Process
• ALLL policy and procedures that are not in compliance with the
Interagency Policy Statement and updates to regulatory guidelines.
• Definitions of Pass; Watch List; Substandard; and, Doubtful loan grades
are not in compliance with best practice guidelines.
• Failure to document the information sources (i.e. past due history; chargeoff history; economic outlook) used for inherent risk factors; especially the
ASC #350 allocation.
• Failure to update inherent risk factors with more current information on a
regular basis (i.e. quarterly; annually; “rolling” process).
• Infrequent schedule of performing loan reviews.
• Poor communication between lending officers and loan reviewer upon
discovery of significant events.
• Internal reviewers who are not independent of the loan origination
process. Loan Originators should not be reviewing loans subsequent to
funding.
• Funding the ALLL provision without proper substantiation as to the
rationale for the amount and properly allocating provisions to specific
loans.
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Appendix 4 – “War Stories”
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Collapse of the commercial and residential real estate markets.
Cash flow not adequate to service debt.
Inadequate provisions allocated to the allowance for loan losses.
Loan reviews are contrary to loan officer’s outlook.
Unperfected liens.
Improper valuations of real estate collateral.
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Appendix 5 - References to ALLL
• 2006 Interagency Policy Statement on the Allowance for Loan and Lease
Losses
• 2012 Interagency Supervisory Guidance on Allowance for Loan and Lease
Losses Estimation Practices for Loans and Lines of Credit Secured by
Junior Liens on 1-4 Family Residential Properties
• ASC #450 (FASB #5) - Accounting for Contingencies
• ASC #310 (FASB #114) – Accounting by Creditors for Impairment of a
Loan
• FRB Commercial Bank Examination Manual - Section 2040 - Loan
Portfolio Management)
• FRB Examination Manual for U.S. Branches and Agencies of Foreign
Banking Organizations - Section 6010 - Asset Quality Classifications
• 2005 Statement of Position No. 03-3 - AICPA Statement of Position 03-3 Accounting for Certain Loans or Debt Securities Acquired in a Transfer
• 1995 Interagency Guidelines Establishing Standards for Safety and
Soundness
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Appendix 6 – Sample Audit Findings
• The Credit Administration, Internal Asset Review, and,
Classification policies should describe the process used in the
calculation and include additional factors and details related
to the ALLL process.
• Ensure the Credit Administration and Internal Asset Review
and Classification Policy is reviewed and approved by the
Board on an annual basis.
• ALLL memorandum provided to the Board of Directors should
comply with regulatory guidelines.
• The Quarterly ALLL memorandum should discuss differences
between the calculated amount and that which is reported in
financial statements.
• Management should ensure that the Loan Quality Rating
downgrades are adequately documented.
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Appendix 7 – ALLL Policy - Methodology For Determining Allowance For
Loan Losses
• ALLOWANCE FOR LOAN LOSS (ALLL) COMMITTEE
The ALLL Committee consists of the President, CCO, CLO, CRO, CFO,
Loan Workout Department Head and the Chairman of the Board.
The Committee meets quarterly to review the adequacy of the ALLL
and methodologies utilized in compiling data from internal reports
noted below.
The data is reviewed and summary reports are prepared by the
Workout Department to properly reflect adjustments in the ALLL
report, including appropriate adjustments to risk ratings and reserve
allocations as required. The CFO working with the CCO prepares a
quarterly ALLL report/memorandum that complies with certain
regulatory and accounting guidelines. This report/
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memorandum is presented to and approved by the ALLL Committee
and Board of Directors each quarter prior to release of operating
results.
• ALLL METHODOLOGY
The Board is responsible for the following in connection with the
ALLL:
Reviews support for qualitative factors used in the ALLL analysis
and ensure that the directional movement of the allocation for
each factor is clearly supported.
Ensures the rationale is appropriately supported and consistently
applied for historical loss rates developed.
Reviews updated evaluations and appraisals for impaired loans
are documented.
Requires periodic independent validation of the Bank’s ALLL
methodology and ensure that the methodology is revised when
appropriate.
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Reviews the Allowance calculation at least once each calendar
quarter. Any deficiency in the ALLL shall be remedied in the
quarter it is discovered by additional provisions for loan losses.
Written documentation shall be maintained indicating the factors
considered and conclusions reached by the Board in determining
the adequacy of the Allowance.
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 original contractual terms of the loan
agreement. The Bank has determined that all troubled debt
restructured loans (“TDRs”) and all Non-Accrual loans are impaired;
however, Non-Accrual loans with an impaired balance of $250,000
or less will be evaluated under ASC 450 (formerly known as FAS 5)
with other groups of smaller or homogeneous loans with similar
risk characteristics. The Bank will use judgment to determine if
there are other loans outside of these two categories that fit the
definition of impaired. For example, accruing
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Substandard loans (risk rated 6) may be considered impaired
based upon recent delinquency or other factors that may put
ongoing payments at risk.
• ASC 310 (formerly FAS 114)
If a loan is considered impaired as defined above and is a 1) TDR,
2) non-accrual loan with an impaired balance of more than
$250,000 or 3) an accruing Substandard loan considered impaired
and with an impaired balance of more than $250,000, the
Commercial Loan Workout Department will complete a ASC 310
(FAS 114) impairment analysis quarterly. Other loans to the
same borrower that are collateralized by the same collateral pool
will be included to determine if the $250,000 threshold has been
reached. If the threshold is reached, the loan (s) will be included
in the ASC 310 pool.
One of three measurement methods will be used to calculate the
amount of the impairment:
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1) Present value of expected future cash flows (discounted cash flow
analysis),
2) Fair value of collateral less costs to sell or
3) Observable market price of loans.
The present value of expected future cash flows method will generally be
used unless:
1) Repayment of the loan is expected to be provided solely by the
underlying collateral and there are no other available and reliable
sources of repayment and/or
2) The loan is more than 60 days past due or has matured and it is
unlikely that the borrower will bring the loan current and/or an
extension will be negotiated and closed (i.e. there is no payment
stream to calculate the present value) or
3) There is an observable market price for the loan. Adjustments for
environmental or qualitative factors may be included.
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If there is no additional reserve or charge-off indicated, then the
loan does not need to be reserved under either ASC 310 or ASC 450
(loans that do not need an additional reserve or charge-off will
remain in the ASC 310 (FAS 114) pool and do not get transferred to
ASC 450 (FAS 5 pool). For a loan that is impaired, no additional loss
recognition is appropriate under ASC 450 even if the measurement
of impairment under ASC 310 results in no allowance.
The Commercial Loan Workout Department maintains the
supporting documentation regarding the discounted cash flow
analyses and/or collateral valuations. Loans less than or equal to
$250,000 will typically have less supporting documentation as the
loans are pooled and allocated a reserve under ASC 450 (FAS 5).
The ASC 310 (FAS 114) calculation will determine the realizable value
of the assets securing the impaired loan. Adjustments for cost to sell
for impaired collateral dependent loans to determine the net
collateral value are as follows:
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• For “arms-length” sales by borrower (property not in foreclosure),
5% brokerage fee for properties valued greater than $1,000,000
and 6% for properties valued less than or equal to $1,000,000,
greater of $4,000 or 0.6% property value for legal fees and amount
of delinquent real estate taxes (if any) are currently being used for
properties where ties collateralizing loans are currently located.
Updates will be obtained periodically from real estate brokers and
law firms to determine if these percentages/dollar amounts are
appropriate and for unique properties/situations where another
percentage/dollar amount may be appropriate.
• For properties in foreclosure, 5% brokerage fee for properties
valued greater than $1,000,000 and 6% for properties valued less
than or equal to $1,000,000, greater of $10,000 or 1.5% of
property value for legal fees, amount of delinquent real estate
taxes (if any), real estate taxes and insurance for two years or
estimated time to complete foreclosure and repairs and
maintenance equal to double the amount in appraisal for two
years or estimated time to complete foreclosure.
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As above, updates from real estate brokers and attorneys will be
obtained on a periodic basis.
• Will contact real estate brokers and law firms as needed to
make sure that these costs to sell are still in line with market
conditions.
ASC 450 (formerly FAS 5)
• Loans which are not impaired will fall into an ASC 450 (FAS 5)
pool reserve, for groups of smaller or homogeneous loans.
• ASC 450 (FAS 5) loss estimates will be based upon past loss
history and other environmental or qualitative factors.
• Reserves should not be layered for double counted;
therefore, loans should either be tested with ASC 310 (FAS
114) or ASC 450 (FAS 5) but not both.
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The Comptrollers Department is responsible for the preparation of the
monthly ALLL analysis. The data is compiled from the spreadsheet(s)
received from the Workout Department and updated at quarter end to
take into account loan payments. As noted above, the CFO working with
the COO compiles a quarterly ALLL report/memorandum. The ALLL
report is reviewed quarterly by the ALLL Committee and by the Board of
Directors.
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The ICS Consulting Partners team thanks you for
attending this presentation.
Questions/comments are welcome at this time.
Contact Information
Chris B. Harris
Managing Director
Telephone - 609-605-6392
E-mail - CHarris@ICSconsultingpartners.com
Robin Ramistella
Director
Telephone - 862-221-8342
E-mail - RRamistella@ICSconsultingpartners.com
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