Back to the Future: The Allowance for Loan and Lease Losses

5-18-15-CRM.pngOne of the most important figures on a bank’s balance sheet is the allowance for loan and lease losses (ALLL), as it provides an estimate for future credit losses. More than a decade ago, the “unallocated” ALLL was the subjective component of the allowance, which was often criticized for being poorly supported. Regulatory guidance issued in December of 2006 attempted to provide a framework to support this portion of the reserve through the use of a Qualitative & Environmental (Q&E) adjustment. However, the financial crisis soon hit and the resultant high historical loss rates lessened the impact of the Q&E adjustment. Now, we are “back to the future;” the industry-wide ALLL was 1.5 percent at the end of 2014 while annual charge-off rates accounted for only one-third of that total. As the Q&E component of the ALLL has grown, the scrutiny over the Q&E from regulators and external auditors has increased proportionately.

Today’s primary regulatory guidance on ALLL is the December 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses. In the section covering the general reserve (Formerly FAS 5, now ASC 450-20), it indicates that while historical loss experience provides a reasonable starting point for the institution’s analysis, management “should consider” those qualitative or environmental factors that are likely to cause the estimated credit losses to differ from historical loss experience. Nine factors are listed and are summarized as 1) lending policies and procedures, 2) economic conditions, 3) nature/volume of portfolio, 4) lending/credit staffing, 5) asset quality, 6) loan review system, 7) collateral valuation, 8) loan concentrations, and 9) other external factors.

Balanced Approach
Q&E methodologies used today range from formulaic approaches to subjective determinations. The regulatory guidance suggests that “management must exercise significant judgment when evaluating the effect of qualitative factors on the amount of the ALLL.”  However, at the subjective end of the spectrum, we begin to resemble the old “unallocated reserve” method which is frequently criticized in today’s Q&E world. Community banks may want to consider a balanced approach, which can be accomplished in five simple steps.

  1. Factor Selection
    This one is easy. Use the nine factors listed in the interagency guidance. You are free to select additional factors if it is relevant to your portfolio, but you should not ignore any of the nine factors.
  2. Data Gathering
    For each of the nine factors, gather the appropriate data. The data should include not only current data, but also trend data that covers a considerable period of time and certainly spans the historical loss period utilized in calculation of the bank’s historical loss rates. Provide data in graph form whenever possible as it facilitates the review and analysis process. Data can come from a variety of sources including the government (federal, state and local), other publicly available data sources, as well as bank and bank peer group data.
  3. Factor Analysis
    The information gathered for each of the nine factors should be analyzed and summarized with an overall assessment of how this factor has changed from the periods covered by the historical loss rates to current conditions. It is also helpful to identify specific loan segments within the portfolio that may deviate positively or negatively from the overall assessment. The overall assessment can be summarized by a letter grade or rating on a numeric scale but other approaches to capturing an overall assessment may be preferable, depending on circumstances.
  4. Q&E Adjustment Setting
    The critical decision is how to best translate the nine-factor assessment into a basis point adjustment for each of the loan categories. One approach is to develop certain adjustment scales for each of the nine factors to be applied to each loan segment. A less formulaic approach would combine the nine-factor assessment with quantitative information regarding each loan segment, such as 1) unadjusted loss rate, 2) historical loss rates for bank and peer group over different time horizons, and 3) sensitivity loss rates informed by adverse case scenarios. This holistic approach would allow management to determine the overall effect of the Q&E factors for each loan segment while being informed by quantified impacts under differing scenarios.
  5. Trend Analysis
    This step is often overlooked as management is just glad to have finished the Q&E adjustment process. The interagency guidance indicates that documentation should include management’s analysis of how each factor has changed over time.  A summary table that captures the trends in the nine-factor assessment and compares it with the trends in the Q&E adjustment by loan category, along with a narrative, could serve as documented support for the directional consistency of the adjustments with the underlying trend information.

While it may seem like a “back to the future,” approach, properly assessing your bank’s Q&E can be accomplished through a structured, consistent, and well-informed method that doesn’t involve rocket science.


David Ruffin


David Ruffin is a principal at IntelliCredit, A Division of QwickRate.  His extensive experience in the financial industry includes an emphasis on credit risk in a variety of roles that range from bank lender and senior credit officer to co-founder of the successful Credit Risk Management, LLC consultancy and professor at several banking schools.  A prolific publisher of credit-focused articles, he is a frequent speaker at trade association forums, where he shares insights gained helping lending institutions evaluate credit risk—in both its transactional form as well as the risk associated with portfolios based on a more emergent macro strategy.  Over the course of decades, Mr. Ruffin has led teams providing thousands of loan reviews and performed hundreds of due diligence engagements focused on M&A and capital raising. 

Randal Rabe