Allowance for loan and lease losses (ALLL): Loss discovery periods

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1 Allowance for loan and lease losses (ALLL): Loss discovery periods In the first installment of our series, Allowance for loan and lease losses (ALLL): Adjustment factors, we explored how and why a bank should adjust its historical loss experience that is, its charge-off rate, the rate at which loans are written down, or charged off for current trends and conditions in order to determine the appropriate charge-off rates for each loan type. This installment explores whether such adjusted charge-off rates require further refinement to reflect the average time between when loss events occur for specific loan types and when such problem loans are identified and the related loss amounts are confirmed through charge-offs. Major ALLL components FAS 5 (Also known as ASC ) FAS 114 (Also known as ASC ) SOP 03-3 (Also known as ASC ) Total allowance This paper, like the first one, focuses on the FAS 5 component of the allowance. The FAS 5 component, often the largest, is for loans that have not been individually identified as being impaired. These loans are likely performing in accordance with contractual terms (or any nonperformance is minor) at the date of the financial statements. Nevertheless, based on past experience or other factors, there is reason to believe that some of these loans have suffered from loss-causing events and/or circumstances that the bank may not be able to specifically identify at the date of the financial statements. For example, a bank may be unaware that a borrower has lost his or her job as of the date of the financial statements, indicating that the loan risk profile has likely increased, but for now the loan is current. Graphically, the allowance might be described as shown below. Background The ALLL, or the allowance, for a bank has several components. The primary components consist of loans collectively evaluated for impairment (the FAS 5 component 1 ), loans individually determined to be impaired (the FAS 114 component 2 ), and loans acquired with deteriorated credit quality (the SOP 03-3 component 3 ). 1 FAS 5 refers to the original FASB pronouncement FAS 5, Accounting for Contingencies, which is included in the FASB Accounting Standards Codification (ASC) subtopic , Contingencies: Loss Contingencies. 2 FAS 114 refers to the original FASB pronouncement FAS 114, Accounting by Creditors for Impairment of a Loan, which is included in the FASB ASC subtopic , Receivables: Overall. 3 SOP 03-3 refers to the original AICPA pronouncement SOP 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer, which is included in ASC subtopic , Loans and Debt Securities Acquired with Deteriorated Credit Quality. Lender s knowledge of loss in specific loans 100% 50% 0% Known losses (confirmed and charged off) Past loss events The allowance for loan losses (for the unknown losses) Reporting date

2 This chart illustrates several things. The horizontal scale represents time leading up to the financial statement reporting date and thereafter, while the vertical scale represents the lender s knowledge of which borrowers and loans have incurred losses. The line at the top represents a steady-state rate of losses occurring in the loan portfolio. First, it shows that losses happening far enough in the past are fully known to the lender and, with their confirmation, they have been charged off prior to the reporting date. There is no allowance needed for these loans. Second, it shows that the closer the loss event is to the date of the financial statements, the less information the lender has about which specific borrowers have incurred a loss and how much loss has been incurred on specific loans. It is for these borrowers and loans that the FAS 5 allowance is needed. Even though specific borrowers and loss amounts may not yet be identified and confirmed, on a pool or portfolio basis the lender can estimate losses being incurred in the period leading up to the financial statement date and record an appropriate allowance for those estimated loan losses. Finally, the chart illustrates that under the incurred Simplified FAS 5 formula Historical loss experience by loan type Adjustments loss model, which is current GAAP, the allowance contains no amount for expected future losses, no matter how predictable they might be. FAS 5 sets forth the general principle for accruing all types of losses insurance, litigation, loan, etc. and requires that losses be estimated and accrued when two conditions are met: Information available before the financial statements are issued or are available to be issued indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur, confirming the fact of the loss. The amount of the loss can be reasonably estimated. Our earlier paper includes more background and discussion, not repeated here, on the conceptual underpinnings for the FAS 5 portion of the allowance. In that paper, we explored the adjustment component of the simplified formula below that is typically the basis for the FAS 5 portion of the allowance. Loan type balance FAS 5 allowance estimate The simplest methodology would take the calculated, average adjusted historical charge-off rate expressed as a percentage of the loan type total balance per quarter or annual period multiplied by the unimpaired balance of loans held at the date of the financial statements. The resulting amount would be the allowance estimate. But refinements to the charge-off rate are usually needed for several reasons: 1. The historical charge-off rate reflects the period over which the charge-offs were confirmed and recognized, not the period over which the earlier losses occurred. That is, the charge-off rate measures the confirmation of losses over a period that occurs after the earlier actual losses. During the period between the loss-causing events and the eventual confirmations of losses, conditions may have changed. 2. There is always a time lag between the period over which average charge-off rates are calculated and the date of the financial statements. During that period, conditions may have changed. 3. The charge-off rates are just that rates of charge-off over a period of time. Refinement of the methodology should be made for the estimated loss discovery period, that is, the average period between when losses occur and when the loans are charged off as a result. 2

3 Expanded FAS 5 formula Historical loss experience by loan type Adjustments Loss discovery period Loan type balance FAS 5 allowance estimate Our earlier paper was primarily concerned with the adjustment factors, that is, refinement of the historical loss experience the charge-off rate that results from items 1 and 2 above. This paper is focused on the refinement that results from the third item, the loss discovery period (LDP). The LDP has been separately illustrated in the expanded formula, shown above. What is the LDP? The LDP, sometimes referred to as the loss emergence period or loss confirmation period, by other names, is the period that it takes, on average, for the bank to identify the specific borrower and amount of loss incurred by the bank for a loan that has suffered from a loss-causing event. In other words, it is the period that starts with the event or culmination of events that cause the borrower to be unable to honor his or her commitment and ends with the confirmation of the loss. For example, it may start when a borrower loses a significant customer that was a primary source of cash flow used for loan repayment. The borrower may continue to pay on the loan for a period of time, but due to the loss of cash flow from the significant client, sustaining the contractual payments may eventually become no longer possible. The lender likely may not become aware that there is a problem until the borrower becomes delinquent on the loan. Once the loan becomes delinquent, the lender will likely try to work out the loan with the borrower, but ultimately may charge off all or a portion of the loan as the actual impact of that loss-causing event (loss of the significant customer) becomes known to the bank with reasonable confidence (confirmation of the loss). Losses may be confirmed by a variety of events and circumstances such as notice of the borrower s discharge of debt through bankruptcy, the lender obtaining control of collateral, or exhaustion of reasonable efforts to collect. Confirmation does not require certainty, and simplifying conventions such as charging off consumer loans when the borrower becomes a set number of days past due are reasonable even when they lead to some low level of recoveries after the charge-offs. The LDP typically progresses as shown below: Loss events culminate in the borrower s inability to repay the loan. The borrower begins to miss payments, and problems become evident to the lender. The lender has sufficient information to confirm the loss and takes the charge-off. Loss discovery period Performance continues so that the loss is not visible. Performance deteriorates so that the loss becomes visible to the lender. 3

4 Why the LDP concept matters to the ALLL As noted in our simplified formula, the measurement of the FAS 5 component often starts with the bank s charge-off rate by loan type adjusted for changes in conditions between the period leading up to the charge-off and the conditions at the date of the financial statements. It is useful to recall that whether the chargeoff rate in the formula is calculated based on an average of one, three or five years of charge-offs divided by the time period selected or some other approach, the charge-off rate generally is stated in terms of an annual rate 4. That is, it is a factor that describes how much in charge-offs for a given loan type have been (and may be expected to be) taken, on average, over a year. It is often assumed, explicitly or implicitly, that multiplication of the adjusted annual rate of charge-offs times the applicable period-end loan balance will compute the appropriate allowance amount. That assumption would be correct if it takes, on average, one year from the loss-causing event for the loan loss to be confirmed and the loss charged off. We note that the charge-off rate (for example, an annual rate) is independent of the loss-averaging period selected for its calculation. The bank could average charge-offs over a five- or 10-year period or over the most recent quarter and use that to calculate an annual charge-off rate. The point of tracking charge-offs and attributing them to loan types and risk categories is to compute appropriate rates. A key point of this paper is that the rate must be combined with a reasonable estimate of the LDP, which might be one year, more than one year or less than one year. So what if it takes a longer or shorter period for losses to be confirmed? If it takes longer or shorter than a year for losses to be confirmed, the time period should be incorporated into the allowance for loan losses such that the allowance is not understated or overstated. However, before we explore how to incorporate the LDP into the FAS 5 allowance, we need to understand what impacts the LDP. What impacts the LDP? Depending on the type of loan and loan administration process, including the frequency and nature of contact with borrowers and collection of third-party credit information, a considerable period of time may pass before the problems become evident to the lender. Once the problem becomes visible to the lender, steps are usually taken to interact with the borrower in an attempt to avoid and minimize any loan losses. The LDP depends on factors such as the following: Nature of the loan and borrower Borrowers may have a propensity to service some types of loans after suffering loss-causing events for shorter or longer periods before defaulting, depending on characteristics of the collateral and/or the borrower. For example, a borrower who needs an automobile to commute to work may stop making payments on other loans before falling behind on the automobile loan. And some borrowers will default on credit card loans long before they fall behind on their home mortgage. Loan terms Monthly payment loans will make problems visible more quickly than quarterly payment loans. Similarly, loans that require principal and interest will make problems more visible than loans that require only interest payments prior to maturity. Loans that mature annually will make problems visible more quickly than loans that have a longer loan term. Loans that allow interest to be paid out of an interest reserve may delay the visibility of problems. 4 We observe that the charge-off rate may be determined using a time period other than a year. 4

5 Loan administration and covenants The frequency at which the lender obtains information, directly or indirectly, and the nature of the information the lender obtains affect the length of the LDP. For example, on larger loans, the loan officer and loan administration staff likely make personal contact with the borrower and interact with the borrower more often than on a smaller loan. Monthly financial statements will make problems visible more quickly than quarterly or annual audited financial statements. Additionally, loan covenants and the frequency of reporting by the borrower of compliance with those covenants (provided there is follow-up by the bank) will allow the bank to more quickly identify problems on specific loans. Also, the frequency at which the bank obtains updated credit scores and collateral revaluations will affect the length of the LDP. Gathering of relevant information on a timely basis is critical, but so is the frequency with which loans are reviewed for credit risk. The frequency of loan reviews and triggers for special loan reviews will affect the length of the LDP. We note that most of these factors are manageable, within limits, by the lender. Incorporating LDP into the FAS 5 allowance Understanding what the LDP is, why it s needed and what impacts the LDP leads us to the following important observations: 1. Assuming the same loss rates, the ALLL should be smaller for pools of loans with shorter LDPs than for pools of loans with longer LDPs. 2. An explicit or implicit assumption in the ALLL calculation that the LDP is one year may be materially incorrect. 3. The LDP is affected by management decisions made over time, including the maintenance of controls, relating to underwriting and loan administration. Pool A Pool B ALLL Most losses more than six months prior to the reporting date have been confirmed and charged off. The ALLL needs to cover losses incurred over the most recent six months that have not been confirmed. Thus, an appropriate annual charge-off rate for the pool should be multiplied by.5 (one-half year). Building on our earlier illustration of the ALLL, the first observation might be illustrated by the following two pools. Pool A contains monthly pay loans (principal and interest) without collateral (for example, credit card balances). Its LDP and resulting ALLL might be illustrated as shown below (top). Pool B contains commercial loans that pay interest quarterly (some out of interest reserves) for which the lender eventually obtains annual, unaudited financial statements and makes personal contact with management once a year. Its LDP and resulting ALLL might be illustrated as shown below (bottom). ALLL Most losses more than 24 months prior to the reporting date have been confirmed and charged off. The ALLL needs to cover losses incurred over the most recent 24-month period that have not been confirmed. Thus, an appropriate annual charge-off rate or the pool should be multiplied by 2 (two years). 5

6 The following excerpt from the Federal Reserve Board s publication (in SR 06-17) of the Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL) indicates an understanding of and acceptance of the use of reasonably determined loss discovery periods. Issued: December 13, 2006 Measurement of Estimated Credit Losses FAS 5 When measuring estimated credit losses on groups of loans with similar risk characteristics in accordance with FAS 5, a widely used method is based on each group s historical net charge-off rate adjusted for the effects of the qualitative or environmental factors discussed previously. As the first step in applying this method, management generally bases the historical net charge-off rates on the annualized historical gross loan chargeoffs, less recoveries, recorded by the institution on loans in each group. Methodologies for determining the historical net charge-off rate on a group of loans with similar risk characteristics under FAS 5 can range from the simple average of, or a determination of the range of, an institution s annual net charge-off experience to more complex techniques, such as migration analysis and models that estimate credit losses. [fn 20] Generally, institutions should use at least an annualized or 12-month average net chargeoff rate that will be applied to the groups of loans when estimating credit losses. However, this rate could vary. For example, loans with effective lives longer than 12 months often have workout periods over an extended period of time, which may indicate that the estimated credit losses should be greater than that calculated based solely on the annualized net charge-off rate for such loans. These groups may include certain commercial loans as well as groups of adversely classified loans. Other groups of loans may have effective lives shorter than 12 months, which may indicate that the estimated credit losses should be less than that calculated based on the annualized net charge-off rate. Our second observation that using an explicit or implict one-year LDP factor in the ALLL calculation may result in a materially incorrect ALLL is also illustrated by the previous graphics. If it does take, on average, two years to identify the borrower and the specific amount of loss in Pool B, then establishing and maintaining an allowance that equals the annual charge-off rate multiplied by one (1) is likely insufficient since it would not capture all losses incurred at the financial reporting date. Similarly, for Pool A, an allowance that equals the annual charge-off rate multiplied by one (1) is likely overstated because it would reflect more unconfirmed losses than have been incurred up to the financial reporting date. The above examples suggest that the applicable LDP might be an exactly determined period and allowances differing from amounts computed using the exactly determined periods would be in error. But this is only for purposes of simplifying examples and not what we believe is acceptable or appropriate. We recognize that LDPs will be estimates and that banks might use LDP factors that fall within a reasonable range. Management should understand that how loan terms are set and how loans are administered have a direct link to the estimate of the needed ALLL, and changes in loan terms and administration can lessen or increase the LDP, and as a result, the needed ALLL. Management, those charged with governance, auditors and regulators should understand and evaluate the linkage between loan terms and administration, and the resulting LDP. Additionally, increases in the LDP may indicate that loan underwriting should be improved and/or loan administration needs improvements. Practically determining the LDP Agreeing that LDPs are important and needed does not mean they become instantly available. So the question has almost certainly come to mind: How might we practically and economically obtain this information on a recurring basis? First, it is important to always bear in mind that the LDP, just like the charge-off rate used in the alllowance calculation, is an estimate likely a rough estimate. It is an average from many loans that share some common characteristics but likely each has its own specific facts and timeline. There is nothing inherently wrong with this imprecision. Our recommendations as to how a bank might derive reasonable LDPs include the following: Discussion with those who would be most knowledgable about LDP The best place to start is with the people who are knowledgeable about each category of loans in your portfolio. Once they understand the LDP concept and its importance to the organization, ask them to estimate the average LDP for the loans they make and administer. They are specialists in the nature of the borrowers and their tendencies to default, so let them use their knowledge to make informed estimates of average LDPs for the existing loan portfolio. Of course they will need to document the facts and experience that lead them to their estimates, and, as time goes on, they will need to update the average LDP estimates and document the basis for changes in the LDP. 6

7 Data collection Adopt a data collection process that will put a factual basis under the estimates and support management s determination of the LDP. Often this requires backtesting from the charge-off to the loss event in order to understand the chain of events that led to the charge-off. As noted above, one component of the LDP, the more visible component, is known to the lender and already sitting in the loan files for charged-off loans. That is, for each charged-off loan, the lender should have information about the time period between the first indication of a problem (for example, first past due) and the date of the charge-off. The collection and averaging of this data will capture one important component of the average LDP. Capturing the other, less visible, component of the time between the losscausing event and the first indication of a problem may require a small change in loan administration practice or documentation. Some banks may capture this data from their loan administration or debt covenants tracking but not make the link to the ultimate charge-off. Alternatively, banks may not make use of all available information; for example, if a borrower on a residential loan begins to be late on payments on other loans with the bank, that information may be a useful data point. In other situations, the loan administration personnel may need to ask the borrower, What was the event or trigger for your eventual default, and when did it occur? Then for each borrower, the answer, if it appears to be credible, needs to documented in the loan file and captured along with other components of the LDP. The combination of the period from the triggering loss event up to first indication to the lender that there was a problem and the period from that first indication to the date of the charge-off is a reasonable approximation of the LDP for a particular loan. The collection and averaging of that information for all or most charge-offs of a given type of loan should provide a reasonable, documented basis for the LDP used in the ALLL calculation. Clearly it will take effort to collect and document reasonable LDPs for each loan type considered separately in the ALLL calculation. However, the effort, once the routine is established, will likely not be complex or expensive. Using the LDP to effectively determine loss adjustment factors In our prior paper on the ALLL, we addressed the adjustment factors that are often needed to adjust historical loss experience charge-off rates to better reflect conditions in the lender s environment when the financial statements are being prepared. We noted that it is expected that there is a link between micro- and macroeconomic factors and loan losses. The collection and analysis of loss-triggering factors for purposes of estimating average LDPs should also be useful in understanding patterns and trends in loss-causing events. Thus, we believe that for purposes of the ALLL calculation, there is a connection and synergy between knowledge of losscausing events within different categories of loans and the ability to make relevant, appropriate adjustments to average chargeoff rates. Concluding and additional thoughts LDPs are important factors in the FAS 5 loan and lease loss allowance estimation methodology, whether or not they are explicitly acknowledged. But when they are explicitly acknowledged, measured and managed, they are a powerful tool for management. In addition to informing the calculation of the ALLL, we believe that tracking average LDPs for different types of loans will provide useful information for management in understanding whether changes need to be made to underwriting and loan administration. The documentation of the basis for and changes in the LDP will aid management in explaining its position to those charged with governance of the bank, and to its regulators, auditors and financial statement users. Having specific data in hand, tracked consistently over a period 7

8 of time and documented in loan files, will support management assessment of the needed ALLL, whether its absolute level is increasing or decreasing. In that regard we recommend the following: Document, document, document This hardly needs explanation, but it is critical: Whether the interested parties are state regulators, federal banking regulators, and/or the SEC, you must have documentation that is consistent with SEC 5 and Federal Financial Institutions Examination Council 6 guidance on documenting your allowance methodology. Explain and prepare Tell interested parties (for example, auditors, regulators, board members) how you plan to develop and incorporate LDP into your ALLL calculation by loan type. Explain that the LDP is a dynamic factor that will adjust, depending on facts and conditions. Explain how it is affected by loan underwriting, terms and administration, and how the collection of LDP information will help effectively manage the bank, not just help calculate the needed ALLL. Grant Thornton LLP can help We offer our clients the following services: Reviews of ALLL methodologies (all components, software and functions) and documentation practices leading to concrete, executable actions to address concerns and regulatory criticisms Reviews of troubled debt restructuring policies and practices Modeling of the impact of changes in the methodology under consideration Merger integration of ALLL methodologies and documentation Training Project management services so that projects are completed while you focus on your business Advice on SOP 03-3 implementation, including reviews of implementation projects already under way Validation of models used for SOP 03-3, loan scoring, ALLL, etc. Reviews of compensation systems and linkage to expected losses Reviews and clarification of underwriting and loan servicing practices, and the linkage to the ALLL balance Special purpose, nonrecurring loan quality reviews Reviews of appraisal policies and processes 5 SEC Staff Accounting Bulletin 102, Selected Loan Loss Allowance Methodology and Documentation Issues. Available at For additional information on topics covered in this document, contact your Grant Thornton LLP adviser or: Dorsey Baskin Banking National Technical Partner T E [email protected] Molly Curl Bank Regulatory National Advisory Partner T E [email protected] Nichole Jordan National Banking and Securities Industry Leader T E [email protected] Jamie Mayer Financial Institution Accounting Advisory Services Managing Director T E [email protected] About Grant Thornton LLP The people in the independent firms of Grant Thornton International Ltd provide personalized attention and the highest quality service to public and private clients in more than 100 countries. Grant Thornton LLP is the U.S. member firm of Grant Thornton International Ltd, one of the six global audit, tax and advisory organizations. Grant Thornton International Ltd and its member firms are not a worldwide partnership, as each member firm is a separate and distinct legal entity. The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP. This publication is not a comprehensive analysis of the subject matter covered and is not intended to provide accounting or other conclusions with respect to the matters addressed in this issue. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at accounting that complies with matters addressed in this publication. For additional information on topics covered in this publication, contact a Grant Thornton client-service partner. Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 8