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Informational Memorandum
Subject:Allowance for Loan Losses
Date of Memorandum:04/26/2004
Expiration Date:
Office:OE
Signed By:Smith, Roland
FCA Contact Person:Holland, Tom
Contact Phone:703-883-4484
List of Attachments:Examination Bulletin: FCA 2004-1

INFORMATIONAL MEMORANDUM


April 26, 2004


To: Chairman, Board of Directors
Chief Executive Officer
Each Farm Credit System Institution

From: Roland E. Smith, Chief Examiner
Office of Examination

Subject: Allowance for Loan Losses

The American Institute of Certified Public Accountants (AICPA) has been active for several years attempting to further refine the accounting guidance for the allowance for loan losses (ALL). Likewise, the Securities and Exchange Commission (SEC) and the federal banking regulatory agencies have issued guidance with the intent of clarifying their expectations regarding the analysis of the ALL and related documentation. The focus of the efforts of both the accounting and regulatory agencies has been to minimize subjectivity by requiring additional support for the ALL, particularly the “general” reserves.

The Farm Credit Administration (FCA) endorses the direction provided by the other regulatory agencies and the AICPA. In July 2001, the SEC issued Staff Accounting Bulletin (SAB) No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues and the federal banking regulatory agencies issued an interagency Policy Statement on Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions. Both issuances focused significant attention on the level of documentation needed by lenders in order to support the amounts in their ALL accounts. On June 19, 2003, the AICPA issued for comment a proposed Statement of Position, Allowance for Credit Losses. This proposal was an attempt to provide guidance on the recognition and measurement of the ALL necessary to comply with generally accepted accounting principles (GAAP). However, for a number of reasons, the AICPA voted on January 28, 2004, to drop this proposed rule in favor of a new project focused on improving disclosure requirements related to credit risk and loan loss allowances. SAB No. 102 and the AICPA project reflect a continued refinement of accounting guidance that will serve to shape industry and Farm Credit System (System) practices in this area. As such, we anticipate that System institutions will begin to incorporate the conceptual framework addressed by SAB No. 102 even in advance of the issuance of formal guidance from the AICPA.

As institutions implement the accounting guidance referenced above, it is critical that boards of directors have policies directing the management of each institution to develop, document, and maintain an appropriate, systematic, and consistently applied process to ensure that the provision for losses and the ALL at each reporting date are adequate and fully supported, and the financial disclosures fully inform stockholders of the basis for the ALL. The board and management are also responsible for ensuring that their institutions have controls in place to consistently determine the ALL in accordance with the institutions’ stated policies and procedures, GAAP, and FCA regulations. During the examination process, FCA examiners will continue to evaluate your ALL policy and process, as well as the ALL analysis and the financial disclosures for compliance with section 621.3 of the regulations. The ALL process and financial disclosures are particularly important where institutions make material changes to their ALL. Consequently, FCA’s examiners will ensure each institution’s analysis fully supports the changes, and the basis for those changes is fully explained in financial disclosures of the institution.

Examiners will also evaluate the impact of changes in the ALL process on capital and risk funds. If an institution determines that the ALL is overstated, any excess amounts in the ALL will need to be reversed through a negative provision for losses. This will result in an increase to current period’s earnings and capital without a notable change in the institution’s risk bearing capacity. Please be mindful that the modification to the ALL process has not altered the overall level of risk facing your institution. We strongly encourage you to continue to focus on all risks that threaten your institution and manage the adequacy of the institution’s risk funds. As you know, a key measure that the examiners use to evaluate the safety and soundness of institutions is based on the level of risk funds in relationship to the amount of adverse and criticized loans.

Because of changes to ALL methodologies, future earnings could be more volatile. Therefore, we encourage each board of directors to establish a minimum level of core earnings that are able to withstand fluctuations in asset quality. With increased volatility, it is likely that the examiners’ Financial Institution Rating System CAMELS ratings for the earnings component will change more frequently to reflect the impact of asset quality changes that may occur in an institution. Examiners will continue to focus on core earnings capacity in their earnings analysis and will evaluate the adequacy of earnings, considering the volatility that results from any changes to the ALL.

FCA agrees that the ALL should reflect current economic conditions and be supported by an analysis of key risk factors indicating the probability of loan losses. To clarify our expectations for the ALL analysis, we have attached a copy of the new Examination Bulletin that examiners will use when evaluating the ALL.

If you have any questions about this Informational Memorandum or the Examination Bulletin, please call Tom Holland, Special Examination and Supervision Division, Office of Examination, at (703) 883-4484, or correspond with him on the Internet at e-mail address hollandt@fca.gov.

Attachment

Exam Bulletin FCA 2004-1.doc