written by Kent Fisher
Vavrinek, Trine, Day & Co., LLP

News this past quarter from the front lines in the ongoing battle between struggling banks and the regulators was not encouraging as we continue to hear about large examination-based adjustments to the Allowance for Loan and Lease Loss (“ALLL”) account, thus prompting the question above.

As the economic recovery continues to flounder, bank management teams are finding it increasingly difficult to set ALLL levels that meet both the rate of return aspirations of their shareholders and the safety and soundness concerns of the regulators.

While still concerned about the details of a bank’s ALLL calculation, it seems clear at this point that the regulators have developed metrics that they are using to help determine what “the” ALLL number should be on a macro basis.  While they are not sharing exactly what those metrics are, one to keep your eye on is the Reserve Coverage Ratio (“RCR”) (Link-Reserve Coverage Ratio Graph 12-31-10).  This ratio is the ALLL divided by “noncurrent” loans, which includes nonaccrual loans and loans past due over 90 days still accruing.  The industry average per the graph at the link above has held steady at about 65% during 2010.  Indications are that anything below a 50% RCR will invite a regulatory adjustment to the ALLL.

When looking at your RCR, keep in mind that nonaccrual loans will likely increase during an exam as regulators continue be much more aggressive than bankers about placing loans on nonaccrual, with Troubled Debt Restructuring (“TDR”) status and lack of documentable global cash flow as common regulatory triggers.

TDR’s continue to be a hot topic in general, with additional reporting requirements and clarification on market rate considerations included in the Supplemental Instructions for the 1st Quarter Call Report (Link-Call Report Supplemental Instructions 1st Quarter 2011).  Also, FASB finalized its project on TDR”s with the April 5, 2011 release of Accounting Standards Update (“ASU”) 2011-(Link-ASU 2011-02).  The finalized project is not materially changed from the exposure draft and is generally expected to increase the incidence of TDR’s through more stringent interpretation of market rate and other pertinent considerations when assessing TDR status.

The new guidance is effective for public companies for interim and annual periods beginning after June 15, 2011 (that is, the quarter ending September 30, 2011 for calendar year-end companies). The guidance further requires public companies to retrospectively evaluate all modifications occurring on or after the beginning of the fiscal year of adoption (that is, January 1, 2011 for calendar year-ends) with any changes to the impairment of the receivable as a result of the adoption applied prospectively (that is, recognized in the 3rd quarter 2011 for calendar year-ends).  Remember that “public” companies in FASB’s world includes private companies whose stock is traded on a local exchange.

The effective date for nonpublic companies is the annual period ending after December 15, 2012 (and interim periods within) which means all modifications occurring on or after January 1, 2012 would be subject to the new guidance.

The delayed effective date for nonpublic companies seems of little significance though, with regulators issuing separate but similar guidance in the aforementioned call report supplemental instructions and the expectation of compliance with most of the key elements of ASU 2011-02 in current examinations.

In addition, the ASU ends the public-entity deferral of TDR disclosures in ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. Public companies must now begin providing TDR disclosures in the period of adoption (that is, the quarter ended September 30, 2011 for calendar-year companies).

ASU 2011-02 does not change the effective date of the disclosures in ASU 2010-20 for nonpublic companies.  The disclosures in ASU 2010-20, including the disclosures about TDRs, apply to nonpublic companies for annual reporting periods ending on or after December 15, 2011. Therefore, a nonpublic company will provide the disclosures required by ASU 2010-20 using the existing guidance for identifying TDRs until it adopts the guidance in ASU 2011-02 in calendar 2012.

With regard to the details of the ALLL calculation itself, an increasing area of regulatory focus appears to be the discounted cash flow calculations used to determine specific reserves on TDR’s.  Monthly cash flow projections that are not supportable by current financial information will generally not be accepted by the regulators.  Similarly, balloon payments cannot simply be placed in the cash flow projection without a known source.  Banks should be using the lower of the scheduled balloon payment or the expected proceeds from the sale of the underlying collateral, based on a recent appraisal.

Another area of regulatory focus is the historical loss rate used in the ALLL calculation.  Banks are fine-tuning their determination of this very important starting point to their calculation with many adopting more sophisticated migration analyses to provide supposedly more meaningful numbers.  Whether these analyses actually provide more meaningful numbers is debatable and beyond the scope of this article.

A more basic concern is the frequency we are seeing banks make basic assumption errors when gathering and computing their historical loss rates.  The most common error we are seeing is the improper use of quarterly loss rates.  The move from annual to quarterly loss rates makes sense as it allows for more recent loss activity to be reflected in the calculation.  However, quarterly loss rates reflect only 3 months worth of losses and the December 13, 2006 FFIEC policy statement on the ALLL clearly states that “generally, an institution should use AT LEAST an annualized, or 12-month average net charge-off rate” when estimating historical loss rates.  A surprising number of banks are not annualizing their quarterly loss rates, thus understating those rates.  Calculations should be reviewed in this regard to ensure compliance with the 12-month annualized loss rate.

All of this comes at a time when the current FAS 5 (ASC 450)/FAS 114 (ASC 310) credit impairment model is soon to be replaced by a completely different model that will likely take ALLL levels even higher.  This comes in the form of an exposure draft issued by FASB last January (Link-FASB Credit Impairment Proposal), expected to take effect in or around 2013.  The new model will move credit impairment from the current incurred loss model to one that is based on expected losses over the entire life of the loan.

This will be a future topic of conversation.  But suffice it to say, if people were looking for a good example of a “kinetic military action” (new politically correct term for war), they need look no further than what’s going on in the ALLL’s of many U.S. financial institutions.

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