Policy Statement on the Allowance for Loan and Lease Losses Offers Most Specific Guidance to Date
By John Miller
Community Bank Advisor, 2007 Winter 

If it seems like the regulatory bodies get together and issue a new policy statement on the allowance for loan and lease losses (ALLL) every two to three years, you’re right. There was a policy statement issued in 1993 which was updated for guidance issued in 1999, 2001, 2004, and most recently, in December 2006. Each of the policy statements included a common framework for determining and documenting the analysis of the ALLL. The most recent release was supplemented with a 16-question Q&A document, which provides further insight to some of the details of the ALLL, and a 5-page attachment outlining the elements of an effective loan-review system.

In light of the December 2006 policy statement, many banks do not anticipate a significant change in the day-to-day management of the ALLL. However, most bankers plan on increasing documentation of allocation percentages, enhancing support for both specific and general reserves, as well as a more formal analysis (of the often discussed) unallocated portion of the reserve.

Many of you may be asking questions related to the recent policy statement. In anticipation of some of those questions, we’d like to share some of our insight with you.

The bank’s regulator has “signed off” on our allowance in the past. Do I have to change anything in my methodology?

It depends. Many calculations include standard percentages applied to pools of loans that are used to determine the balance in the allowance. In some cases, the extent of the documentation for these “standard percentages” is a response “that they are accepted by industry and/or regulators.” Other calculations include a detailed historical loss calculation that is adjusted and then applied to pools of loans. In some cases, documentation to support the adjustment is vague or nonexistent altogether.

The recent guidance specifically says it is inappropriate to use a “standard percentage” as the sole determinant for the amount to be reported as the ALLL on the balance sheet. Moreover, an institution should not simply default to a peer ratio or a “standard percentage.” Considering this direct wording from the policy statement, it is imperative that all assumptions and calculations included in the analysis be well supported with current documentation. We will continue to work with our clients in applying guidance and implementing a reasonable approach to analyzing the ALLL.

Should I expect any changes from how my auditors will react based on the December policy statement?

The audit of the ALLL has evolved over the years much like the analysis has evolved. As financial institutions have enhanced the pure calculation and incorporated more principles discussed in the accounting literature, auditors have had opportunities to assist the institutions in interpreting the accounting principles. This policy statement offers the most specific guidance to date as to the dos and don’ts with respect to applying accounting literature.

Further, over the last several years, most of our audit clients have received formal written communication related to the allowance for loan losses, typically in the form of a management letter comment. The comments typically relate to the need for more documentation regarding support for assumptions and specific conclusions in the analysis. This interagency policy statement reiterates the requirement for management to document or support conclusions related to specific, general, and unallocated reserves.

Additionally, in recent years, we have attempted to be proactive with our clients by providing our insight and further guidance on practical implementation of the prior interagency policy statements. One such item is the ALLL validation. A few of our clients have asked us to assist in validating the ALLL methodology. This requirement was discussed in the 2001 interagency statement.

What does it mean to have a methodology validated, and who can perform a validation?