ALLOWANCES FOR LOANS AND LEASE LOSSES- Part 1

The Allowances for Loans and Lease Losses (ALLL) is a valuation reserve established and maintained by charges against the bank’s operating income. As a valuation estimate, it is an estimate of uncollectible amounts that is used to reduce the book value of loans and leases to the amount that is expected to be collected.  The ALLL forms a part of Tier-2 Capital; hence it is maintained to cover losses that are probable and estimable on the date of evaluation. It is not a cushion against all possible future losses; that protection is provided by the Tier 1 Capital. For establishing and maintaining an adequate allowance, a bank must:

• Understand the purpose of the allowance
• Be able to recognise its problems loans in a timely manner.
• Have a sound analytical process for estimating the amount of inherent loss in its loan portfolio.

To establish an adequate allowance, a bank must be able to recognise when the loans become a problem. An effective loan review system and control is essential to identify, monitor and manage asset quality system and problem in an accurate and timely manner. An effective loan review system must be able to identify the:

• Obvious indicators of a problem, such as delinquency.
• Subtle warning of the conditions that may affect the ability of the borrowers to repay on a timely basis, such as deterioration in a borrower’s financial statements or adverse market developments.

The condition and events that cause a loan to be classified by a bank’s loan review system, also indicates that an inherent loss exists in the loan. It is these inherent (but unconfirmed) losses that must be recognised and provided for in the bank’s allowances. Let us discuss these two types of loans: (1) Unconfirmed losses (2) Confirmed Losses.

• Unconfirmed losses: The allowances are general reserves for unconfirmed losses. Unconfirmed losses are those losses which does not have a surety of occurring. They may or may not occur. These losses arise from accounts which are still performing in the books of the banks, with a probability of default over the next twelve months. Any unconfirmed losses must be treated as a ‘general reserve’ or ‘pooled reserve’
• Confirmed losses: Such losses are to be charged off as soon as they are identified. Irrespective of the fact that whether the loan is unsecured or collateralised, banks must charge off as soon as they are identified.

It is important to understand the soundness of the bank’s allowance determination process. Here we discuss models and analytical frameworks relating to estimating inherent losses and an adequate level for the allowance for loans and lease losses. There are two analytical frameworks for determining reserves: (i) As per FAS 5 (General Reserve models) (ii) As per FAS114 (Specific Reserve models).

In the next few blogs we will discuss these frameworks in greater details and the pros and cons associated with each. We will focus on the statistical model development frameworks associated with each approach and the respective advantage and limitation of each process.