Basics Part I
Chris Emery Director of Special Projects MST
ALLL: Back to Basics Part I
Chris Emery, MST
ALLL: Back to Basics Part I • What is the ALLL?
• Incurred vs Expected • ASC 310-10 • ASC 450-20: Segmentation
Part II • ASC 450-20: Quantitative • ASC 450-20: Qualitative • Acquired Loans
What is the ALLL? The Allowance for Loan & Leases Losses (ALLL) is intended to be a “cookie jar” for financial institutions to use to smooth earnings by tucking away excess earnings during successful quarters and supplementing earnings during periods of lower profitability.
WRONG
What is the ALLL? An appropriate ALLL covers estimated credit losses on individually evaluated loans that are determined to be impaired as well as estimated credit losses inherent in the remainder of the loan and lease portfolio.
“Estimated credit losses” means an estimate of the current amount of loans that it is probable the institution will be unable to collect given facts and circumstances as of the evaluation date. 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses
Components of the ALLL • Loans Collectively Evaluated for Impairment (ASC 450-20 f/k/a FAS 5) • Loans Individually Evaluated for Impairment (ASC 310-10 f/k/a FAS 114) • Purchased Credit-Impaired Loans (ASC 310-30 f/k/a SOP 03-3)
• Unallocated Reserves
Incurred vs. Expected (CECL) Under current GAAP, incurred losses are losses that are probable to have occurred, but have not yet been confirmed. Under CECL, expected losses are losses that are expected over the remaining lives of the loans. Incurred losses are a subset of expected losses and therefore would be lower than expected losses.
Incurred vs. Expected (CECL) Incurred
Expected (CECL)
• “Probable” Threshold
• Losses Booked Day 1
• Past Events
• Past Events
• Current Conditions
• Current Conditions • Reasonable & Supportable Forecasts
ASC 310-10 Loans Under [ASC 310-10], an individual loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. It is implicit in these conditions that it must be probable that one or more future events will occur confirming the fact of the loss. Source: 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses
ASC 310-10: Identification • Use normal review procedures (watch lists, past due lists, nonaccrual loans, TDRs) • Groups of “smaller-balance” homogeneous loans can be scoped out – UNLESS TDRs
ASC 310-10: Measurement Methods for Measuring Impairment • Fair Value of Collateral • Present Value of Future Cash Flows • Observable Market Price of the Loan
ASC 310-10: Measurement Fair Value of Collateral Method: What is it? • Determination of loan impairment based on the fair value of the underlying collateral • Only allowable method for collateral dependent loans • Most common method for most institutions
ASC 310-10: Measurement Fair Value of Collateral Method: Basic Calculation Recorded Investment in the Loan - Fair Value of Underlying Collateral
Amount of Impairment
ASC 310-10: Measurement Present Value of Future Cash Flows Method What is it? • Determination of loan impairment based on present value (NPV) of future cash flows • Most commonly used on performing TDR loans to determine concession value
• Second most common method for most institutions
ASC 310-10: Measurement Present Value of Future Cash Flows Method Basic Calculation Recorded Investment in the Loan - Present Value of Future Cash Flows (discounted at the original effective interest rate of the loan)
Amount of Impairment
ASC 310-10: Measurement Present Value of Future Cash Flows Method Special Considerations • If there is a balloon payment, do you have enough support to use the full amount in your calculation? • In lieu of a balloon payment, could you use the fair value of the underlying collateral? • Do you have enough support for the cash flow stream or should it be discounted additionally for uncertainty of collectability?
ASC 310-10: Measurement Observable Market Price Method What is it? • Determination of loan impairment based on value of the loan itself on the open market
• Very uncommon for most institutions
ASC 450-20 Loans • Loans not determined to be already impaired • Loans segmented into groups (“pools”) with similar risk characteristics • Once segmented, pools become the basis for estimating incurred losses based on past events (quantitative) and current conditions (qualitative) • Estimated losses may represent a single large loss within the pool, or many smaller losses
ASC 450-20: Segmentation Each institution must determine the segments that best represent the estimate of losses within the portfolio. Management should use all available information make the determinations: differences in lending areas, underwriting, geographic considerations, etc.
ASC 450-20: Segmentation The “Goldilocks” Principal “Not too big, not too small, but just right” Loan segments must be large enough to form a statistically significant sample, while still being granular enough to represent loans with similar risk characteristics.
ASC 450-20: Segmentation Other Considerations • 5% - 10% rule of thumb • Size and volume of institution and loan portfolio may necessitate more or less segmentation
ASC 450-20: Segmentation Geographic Sub-Segments When sub-segmenting loans by geographic segments, careful consideration must be given to making sure the benefits of increased granularity outweigh the loss of sample size.
ASC 450-20: Segmentation Geographic Sub-Segments Do the different geographic areas actually represent different economies, and therefore different risks of loss?
ASC 450-20: Segmentation Risk-Based Sub-Segments Risk-based sub-segments can help to differentiate different loss rates or default probabilities of loans with different risk characteristics within a collateral or purpose-based segment.
ASC 450-20: Segmentation Risk-Based Sub-Segments • Risk Grades • Delinquency Rates • Other (credit scores, LTV, etc)
ASC 450-20: Segmentation Risk-Based Sub-Segments Risk-based sub-segments should be accompanied by a methodology to differentiate the allowance allocations between the different sub-segments. Can be accomplished quantitatively or qualitatively.
ASC 450-20: Segmemtation Risk-Based Sub-Segments Qualitative methodology may be as simple as adding additional Q factors to the higher risk segments. Quantitative methodologies to differentiate allocations could include PD/LGD or loss migration calculations.
ASC 450-20: Segmentation Risk-Based Sub-Segments Qualitative Methodology • Easier to implement • Management discretion
• Harder to support
ASC 450-20: Segmentation Risk-Based Sub-Segments
Quantitative Methodology • More sophisticated, requires more data
• Directionally consistent • More supportable
ALLL: Back to Basics I
Questions or Additional Discussion?
ALLL: Back to Basics Part I
Chris Emery, MST
ALLL: Back to Basics Part I • What is the ALLL?
• Incurred vs Expected • ASC 310-10 • ASC 450-20: Segmentation
Part II • ASC 450-20: Quantitative • ASC 450-20: Qualitative • Acquired Loans
What is the ALLL? The Allowance for Loan & Leases Losses (ALLL) is intended to be a “cookie jar” for financial institutions to use to smooth earnings by tucking away excess earnings during successful quarters and supplementing earnings during periods of lower profitability.
WRONG
What is the ALLL? An appropriate ALLL covers estimated credit losses on individually evaluated loans that are determined to be impaired as well as estimated credit losses inherent in the remainder of the loan and lease portfolio.
“Estimated credit losses” means an estimate of the current amount of loans that it is probable the institution will be unable to collect given facts and circumstances as of the evaluation date. 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses
Components of the ALLL • Loans Collectively Evaluated for Impairment (ASC 450-20 f/k/a FAS 5) • Loans Individually Evaluated for Impairment (ASC 310-10 f/k/a FAS 114) • Purchased Credit-Impaired Loans (ASC 310-30 f/k/a SOP 03-3)
• Unallocated Reserves
Incurred vs. Expected (CECL) Under current GAAP, incurred losses are losses that are probable to have occurred, but have not yet been confirmed. Under CECL, expected losses are losses that are expected over the remaining lives of the loans. Incurred losses are a subset of expected losses and therefore would be lower than expected losses.
Incurred vs. Expected (CECL) Incurred
Expected (CECL)
• “Probable” Threshold
• Losses Booked Day 1
• Past Events
• Past Events
• Current Conditions
• Current Conditions • Reasonable & Supportable Forecasts
ASC 310-10 Loans Under [ASC 310-10], an individual loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. It is implicit in these conditions that it must be probable that one or more future events will occur confirming the fact of the loss. Source: 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses
ASC 310-10: Identification • Use normal review procedures (watch lists, past due lists, nonaccrual loans, TDRs) • Groups of “smaller-balance” homogeneous loans can be scoped out – UNLESS TDRs
ASC 310-10: Measurement Methods for Measuring Impairment • Fair Value of Collateral • Present Value of Future Cash Flows • Observable Market Price of the Loan
ASC 310-10: Measurement Fair Value of Collateral Method: What is it? • Determination of loan impairment based on the fair value of the underlying collateral • Only allowable method for collateral dependent loans • Most common method for most institutions
ASC 310-10: Measurement Fair Value of Collateral Method: Basic Calculation Recorded Investment in the Loan - Fair Value of Underlying Collateral
Amount of Impairment
ASC 310-10: Measurement Present Value of Future Cash Flows Method What is it? • Determination of loan impairment based on present value (NPV) of future cash flows • Most commonly used on performing TDR loans to determine concession value
• Second most common method for most institutions
ASC 310-10: Measurement Present Value of Future Cash Flows Method Basic Calculation Recorded Investment in the Loan - Present Value of Future Cash Flows (discounted at the original effective interest rate of the loan)
Amount of Impairment
ASC 310-10: Measurement Present Value of Future Cash Flows Method Special Considerations • If there is a balloon payment, do you have enough support to use the full amount in your calculation? • In lieu of a balloon payment, could you use the fair value of the underlying collateral? • Do you have enough support for the cash flow stream or should it be discounted additionally for uncertainty of collectability?
ASC 310-10: Measurement Observable Market Price Method What is it? • Determination of loan impairment based on value of the loan itself on the open market
• Very uncommon for most institutions
ASC 450-20 Loans • Loans not determined to be already impaired • Loans segmented into groups (“pools”) with similar risk characteristics • Once segmented, pools become the basis for estimating incurred losses based on past events (quantitative) and current conditions (qualitative) • Estimated losses may represent a single large loss within the pool, or many smaller losses
ASC 450-20: Segmentation Each institution must determine the segments that best represent the estimate of losses within the portfolio. Management should use all available information make the determinations: differences in lending areas, underwriting, geographic considerations, etc.
ASC 450-20: Segmentation The “Goldilocks” Principal “Not too big, not too small, but just right” Loan segments must be large enough to form a statistically significant sample, while still being granular enough to represent loans with similar risk characteristics.
ASC 450-20: Segmentation Other Considerations • 5% - 10% rule of thumb • Size and volume of institution and loan portfolio may necessitate more or less segmentation
ASC 450-20: Segmentation Geographic Sub-Segments When sub-segmenting loans by geographic segments, careful consideration must be given to making sure the benefits of increased granularity outweigh the loss of sample size.
ASC 450-20: Segmentation Geographic Sub-Segments Do the different geographic areas actually represent different economies, and therefore different risks of loss?
ASC 450-20: Segmentation Risk-Based Sub-Segments Risk-based sub-segments can help to differentiate different loss rates or default probabilities of loans with different risk characteristics within a collateral or purpose-based segment.
ASC 450-20: Segmentation Risk-Based Sub-Segments • Risk Grades • Delinquency Rates • Other (credit scores, LTV, etc)
ASC 450-20: Segmentation Risk-Based Sub-Segments Risk-based sub-segments should be accompanied by a methodology to differentiate the allowance allocations between the different sub-segments. Can be accomplished quantitatively or qualitatively.
ASC 450-20: Segmemtation Risk-Based Sub-Segments Qualitative methodology may be as simple as adding additional Q factors to the higher risk segments. Quantitative methodologies to differentiate allocations could include PD/LGD or loss migration calculations.
ASC 450-20: Segmentation Risk-Based Sub-Segments Qualitative Methodology • Easier to implement • Management discretion
• Harder to support
ASC 450-20: Segmentation Risk-Based Sub-Segments
Quantitative Methodology • More sophisticated, requires more data
• Directionally consistent • More supportable
ALLL: Back to Basics I
Questions or Additional Discussion?
