These days, you must have more than just the right answer for your ALLL reserve calculation, says Drew Roberts, President of Burton, Roberts & Meredith, LLC
. In this guest column, Roberts discusses how ALLL regulation has changed and what institutions can do to improve.
3 is the new 1.5
By Drew Roberts
As I was growing up, there was a popular album titled “What were once vices are now habits.” Thirty years ago, allowance for loan and lease loss was an excellent way to manage earnings. Even after the 1980’s S & L crisis, ALLL was not viewed as a management tool for estimating losses, but rather a management tool for earnings. Bankers universally targeted ALLL by experience. It was not uncommon to have an ALLL under 1% and still be considered sane. Oh how things have changed! What was once 1.5% is now 3.0%.
Throughout the 1990’s and into the 2000’s, ALLL
was shaped and molded by various regulatory interpretations. Gone was the educated guess work, replaced by analysis. Bankers were hearing (and continue to hear), “your methodology is sound, but the allowance is too low.” Or, “your allowance is adequate but your methodology isn’t.” This seems to be a paradox similar to what Einstein faced just before he published his special theory of relativity.
Now we stand at the dawn of even a more perplexing requirement. For institutions with a below average ALLL reserve
, regulators know before beginning an examination the ideal allowance level. If the methodology does not calculate to that number (and isn’t exceedingly documented and justified to show why), it will be criticized. If the methodology calculates to the correct number but is not documented and justified as to how it got there, it will be criticized.
It is not sufficient to merely have the right answer. You now must show your work. Since 1998, ALLL has been the topic of many discussions. Most bankers have felt the frustration of trying to explain their rationale, only to have a regulator defiantly, and with all the authority of their office, negate one argument after another.
Most popular now is what constitutes adequate history for the FAS 5 (ASC 450-20) pools
. After the meltdown in 2008, the regulatory pendulum swung right to the point of absurdity. Many banks that had experienced no losses in their portfolio for years experienced some asset shock. Regulators were eager to point out that a history of no losses was inadequate to predict future losses. Boy, were they right.
Beginning in 2009 and up to the present, examiners have looked for banks to incorporate this dark time of 2008-2011 into their loss history. It became so absurd that regulators were actually requiring banks in 2010 to use only 12 months history because it better reflected future losses. Now, examiners have looked at the historical data to see if it included the years of the most loss. Before 2008, history was just that: the more the better. Now, not so much.
So, what can a bank do? Most banks now have between 2.0% and 3.5% in their ALLL. If you know the final outcome, the only thing left is to “show your work.” By showing how you calculated 3%, regulators will be satisfied that you know what you are doing, whether it makes any sense or not. A comprehensive FAS 5 modeling
can assist you in providing this methodology, provided you can explain the cause and effect in your model.
Don’t worry, though, because once you have this all figured out, it will change. It always does. Just don’t make your vices of today be your habits of tomorrow.
Drew Roberts has been involved in Burton, Roberts and Meredith (BRM) for the last decade concentrating on ALLL, interest rate risk and portfolio shock analysis. The firm dedicates itself to asset reviews and various compliance issues. He can be reached at 801-487-1340.
For updated regulatory guidance, questions, discussions or latest news on the allowance for loan and lease losses, join the LinkedIn group: ALLL Forum for Bankers.