Impacts of financial decisions
Your Financial Institution’s ALLL Model May Be Due for a Check-Up
Like visiting a doctor for a physical, your financial institution should periodically test the health of its Allowance for Loan and Lease Losses (ALLL) model. It’s not just a good business practice (an underfunded ALLL overstates equity and earnings and casts doubt on management’s ability to accurately report the institution’s financial condition), it’s a regulatory requirement.
The Interagency Policy Statement on the Allowance for Loan and Lease Losses says the validation process should include “procedures for a review, by a party who is independent of the institution's credit approval and ALLL estimation processes, of the ALLL methodology, and its application in order to confirm its effectiveness.”
The statement goes on to say that the independent party could be:
- The internal audit staff
- A risk management unit of the institution
- An external auditor (subject to applicable auditor independence standards)
- Another contracted third party from outside the institution
Board of directors responsibility
The board of directors is responsible for requiring management to periodically validate and, when appropriate, revise the ALLL methodology. ALLL validation is a low-cost, high-benefit undertaking that:
- Is inexpensive to perform
- Helps avoid preventable financial statement errors
- Gives peace of mind to management and directors
- Fulfills regulatory requirements
It is not uncommon for an error in the ALLL calculation to cause an institution to record tens or hundreds of thousands of dollars of additional bad debt expense. An annual financial statement audit provides reasonable assurance that the ALLL is materially correct. A validation takes a deeper look at the process for calculating the ALLL.
ALLL validation process
Testing your ALLL spreadsheets consists of a number of steps:
Discovering mathematical errors
A surprising number of ALLL computations contain data input or mathematical errors. Historical loss percentages are frequently misstated. In the rush to complete the calculation, preparers sometimes ‘hard code’ an amount when the spreadsheet’s formula doesn’t generate the expected answer. This hard coded number then gets carried forward into the next month’s calculation without getting updated. Sometimes, formulas don’t take every possible situation into account and this creates bad results. Many errors can creep into ALLL computation; a validation process can help find and correct them.
Testing for impaired loans
Independent reviewers will test the reserves for impaired loans. They determine if the financial institution is using the correct definition for impaired loans and examine past-due reports for loans that are impaired, but not included in the impaired loan analysis. At this point, the review also inquires about restructured loans to make sure all troubled debt restructurings are treated as impaired.
Testing for reasonableness of qualitative factors
An institution’s historical loss experience is the starting point for calculating the ALLL. The loss experience rate is increased or decreased for environmental or qualitative factors such as trends in the local, regional, or national economy, or changes in the value of underlying collateral. The reviewer discusses the qualitative factors with management, analyzes the supporting documentation, and assesses overall reasonableness.
The independent reviewer can step back from the detail to perform analytical tests, including a comparison with peer group data and testing for directional consistency. This simply means that as financial conditions deteriorate, the institution’s ALLL increases; as conditions improve the ALLL declines. In the past downturn, the ALLL of many institutions did not grow as the economy slid into recession. Ratios may include: the ALLL to total loans, the ALLL coverage ratio, and the ALLL to net losses. The reviewer also looks for trends in past due and nonperforming loans.
The final report
Finally, the reviewer reports his or her findings, conclusions, and recommendations to management and the board of directors.
How we can help
Our experienced professionals can help your board and management team confirm the effectiveness of your ALLL model. Using well-defined processes, we will work with your personnel to help you meet all of your regulatory requirements.