One of the ways the Allowance for Loan and Lease Losses (ALLL) is impacted occurs when a financial institution grants a concession through modification of the terms of a loan due to the financial difficulty of the borrower. This is called a Troubled Debt Restructure (TDR).

Understanding whether a particular concession is material enough to qualify the loan as a TDR, or whether the cause of the concession is truly the financial difficulty of the borrower, is critical in determining the appropriate balance for the Allowance for Loan and Lease Losses.

And since that balance determines the expense, 'Provision for Loss', which determines profits for the period, which determines capital levels...the cascading impact of the wrong decision on a TDR can be significant.

Further, if an examiner or outside auditor does not think your bank or credit union is getting this right, it reduces confidence in the entire ALLL and in other major judgement areas as well...another cascading impact.

Two elements

Concession

Just changing terms does not mean you have made a concession. If your financial institution renegotiates to a lower interest rate because you want to keep the customer who could get that lowered rate elsewhere, that is not a concession. That is just good business.

But if you drop the interest rate or extend payments or allow interest-only for a short period which results in terms so favorable the borrower could not get them elsewhere, that is a concession.

But wait, there is more...

Financial Difficulty

If you make a concession just to keep a customer because you don't want to lose their business, but they are not in financial difficulty, then it is not a Troubled Debt Restructure.

Some of the indicators that a borrower may be in financial difficulty even though they are currently paying your loan as agreed include

  • they are out of compliance with another loan
  • you have updated your cashflow forecast and it does not appear they will be able to continue paying your loan as agreed
  • they have filed for bankruptcy
  • their CPA-prepared financial statements indicate in the CPA letter that there is substantial doubt that the company is a going concern

So what's a financial institution to do?

Make sure you are current on the rules for TDRs. The Financial Accounting Standards Board (FASB) has issued an update, Accounting Standards Update (ASU) No. 2011-02, Receivables (Topic 310): A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring, that is effective for nonpublic entities for annual periods ending on or after Dec. 15, 2012.

Be sure your software solution for the Allowance for Loan and Lease Losses (ALLL) handles TDRs correctly. (I like Sageworks Surety.) Identify correctly which impaired loans should be selected for TDR status. Document your thinking on why, or why not, you will treat that loans as a TDR.

The more transparent your thought process and decision-making, particularly if the examiners and outside auditors agree with your findings, the better.

Resources


Allowance for Loan and Lease Losses: ALLL

This is often thought of as a reserve, a set-aside for the fact that some borrower is not going to pay. Which borrower? We don't know, otherwise we would not have lent to them.

Going up?

The Allowance increases in one of two ways:

The financial institution recognizes an expense, the Provision for Loan and Lease Losses, to build the Allowance to the 'best guess' required to prepare for loans that will not be collected. This guess is based on a rather complicated, and extensive process of

  • identifying loans that are at risk (impaired) and determining the likely amount that might be received, and
  • applying a historical loss rate, modified for today's environment, to the remaining loans on the books.

Recoveries outpace charge-offs. This is the least painful way to build (or rebuild) the allowance and results when the financial institution recovers previously charged-off loans faster than the decision to charge-off other loans.

This may happen when a recession truly turns the corner into recovery and loans perform better than expected.

The impact of an increasing ALLL

If it goes up as a result of booking the expense, the increase reduces profits and the resulting addition to capital for that period. Shareholders may not be as happy, but examiners and auditors likely will be.

If it goes up as a result of improving recoveries, everyone is likely to be happy.

Either way, if the guess as to the ALLL is a good one, the balance sheet more accurately reflects the loans receivable. Anyone trying to understand how well (or not) the bank or credit union is doing should appreciate that.

This article,The Allowance for Loan and Lease Loss Becomes a Heavier Burden for Credit Unions, includes my thoughts on one of the up-and-coming challenges for credit unions and banks in keeping up with the time necessary to review loans for impairment to calculate ALLL accurately at the same time that loan volume is (finally) ticking up.

Read the article...

The issues this article touch on are the very same for community banks.

BTW...I have a strategic partnership with the software company, Sageworks, mentioned in the article. They have a new software solution for ALLL and my clients, readers and subscribers get a significant discount. Let me know if you are interested in a demo and I'll get you the discount!
Are you having any trouble at all keeping up with all the terms and acronyms related to bank challenges and failures? Is it hard to be that knowledgeable banker at the cocktail party or the business meeting when you stumble over terms and acronyms?

Here is the glossary of terms and the acronym list from the Material Loss Review Report on 'my' failed bank. I was a shareholder in the 92nd bank to fail and found the 43 page report interesting reading. Okay, I didn't read it, I skimmed it.

Adversely Classified Assets
Assets subject to criticism and/or comment in an examination report. Adversely classified assets are allocated on the basis of risk (lowest to highest) into three categories:

  • Substandard
  • Doubtful
  • Loss
Allowance for Loan and Lease Losses (ALLL)
Federally insured depository institutions must maintain an ALLL that is adequate to absorb the estimated loan losses associated with the loan and lease portfolio (including all binding commitments to lend). To the extent not provided for in a separate liability account, the ALLL should also be sufficient to absorb estimated loan losses associated with offbalance sheet loan instruments such as standby letters of credit.

Call Report Consolidated Reports of Condition and Income
Also known as the Call Reports, these are reports that are required to be filed by every national bank, state member bank, and insured nonmember bank pursuant to the Federal Deposit Insurance Act. These reports are used to calculate deposit insurance assessments and monitor the condition, performance, and risk profile of individual banks and the banking industry.

Cease and Desist Order (C&D)
A formal enforcement action issued by financial institution regulators to a bank or affiliated party to stop an unsafe or unsound practice or violation. A C&D may be terminated when the bank's condition has significantly improved and the action is no longer needed or the bank has materially complied with its terms.

Collateralized Debt Obligation (CDO)
CDOs are a type of structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. CDO securities are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.

Collateralized Mortgage Obligation (CMO)
CMOs are created when individual mortgage loans are packaged or pooled by issuers and offered to sale to investors. There are two types of issuers - agency and private label. Agency-issued mortgage-backed securities meet specific underwriting criteria whereas private label issues generally comprise nonconforming loans.

Concentration
A concentration is a significantly large volume of economically related assets that an institution has advanced or committed to a certain industry, person, entity, or affiliated group. These assets may, in the aggregate, present a substantial risk to the safety and soundness of the institution.

Investment Grade
Investment grade generally means a security that is rated in one of the four highest rating categories by two or more nationally recognized statistical rating organizations.

Other Than Temporary Impairment (OTTI)
An impairment of a debt instrument occurs when the fair value of the security is less than its amortized cost basis. According to accounting standards, when the impairment is judged to be other than temporary, the cost basis of the individual security must be written down to fair value, thereby establishing a new cost basis for the security and the amount of the write-down must be included in earnings as a realized loss.

Prompt Corrective Action (PCA)
The purpose of PCA is to resolve the problems of insured depository institutions at the least possible long-term cost to the DIF. Part 325 of the FDIC Rules and Regulations, 12 Code of Federal Regulations, section 325.101, et seq, implements section 38, Prompt Corrective Action, of the FDI Act, 12 United States Code section 1831o, by establishing a framework for taking prompt corrective supervisory actions against insured nonmember banks that are less than adequately capitalized. The following terms are used to describe capital adequacy:
 
  • Well Capitalized
  • Adequately Capitalized
  • Undercapitalized
  • Significantly Undercapitalized
  • Critically Undercapitalized.
Tranches
Multiple classes of equity and debt that are set in a senior or subordinate position to one another based upon seniority in bankruptcy and timing of repayment. The tranches are divided into three general categories:
 
  1. Senior tranche
  2. Mezzanine tranche
  3. Equity tranche
Uniform Bank Performance Report (UBPR)
The UBPR is an analysis of financial institution financial data and ratios that includes extensive comparisons to peer group performance. The report is produced by the Federal Financial Institutions Examination Council for the use of banking supervisors, bankers, and the general public and is produced quarterly from Call Report data submitted by banks.

Acronyms:
ADC Acquisition, Development, and Construction
ALLL Allowance for Loan and Lease Losses
ARD Assistant Regional Director
BOLI Bank-Owned Life Insurance
BSA Bank Secrecy Act
C&D Cease and Desist Order
CAMELS Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk
CD Certificate of Deposit
CDO Collateralized Debt Obligation
CMO Collateralized Mortgage Obligation
CRE Commercial Real Estate
DIF Deposit Insurance Fund
DRR Division of Resolutions and Receiverships
DSC Division of Supervision and Consumer Protection
EIC Examiner-in-Charge
FDI Federal Deposit Insurance
FHLB Federal Home Loan Bank
FHLMC Freddie Mac - Federal Home Loan Mortgage Corp
FIL Financial Institution Letter
FNMA Fannie Mae - Federal National Mortgage Association
GAGAS Generally Accepted Government Auditing Standards
GSE Government Sponsored Enterprise
LTV Loan to Value
OIG Office of Inspector General
ORL Off-site Review List
OTTI Other Than Temporary Impairment
PCA Prompt Corrective Action
RO Regional Office
ROE Report of Examination
SEC Securities and Exchange Commission
UBPR Uniform Bank Performance Report
UFIRS Uniform Financial Institutions Rating System

Got that? No, there won't be a quiz!

Do you have any to add to the list?