|FCA Examination Manual|
|Section||Allowance for Loan Losses|
The regulations of the Farm Credit Administration (FCA) require Farm Credit System (System) institutions to maintain an allowance for loan losses (ALL) in accordance with generally accepted accounting principles (GAAP). The ALL is required to be maintained at a level that is adequate to absorb the estimated amount of probable losses in the institution's loan portfolio and its lease financing portfolio at the date of the financial statements.
GAAP requires the impairment of loans to be recognized through an addition to the ALL when, based on all available information, it is probable that a loss has been incurred based on past events and conditions existing at the date of the financial statements. As used in this section, the ALL is intended to include the allowance for all probable and estimated credit losses in an institution’s loan and lease portfolios. The ALL does not include allowances for estimated losses on acquired property or for estimated losses due to any off-balance sheet exposure the institution may have. Acquired property should be recorded at its fair value less costs to sell. An allowance for off-balance sheet exposures, (for example, off-balance sheet loan commitments, standby letters of credit, and guarantees, etc.) must be reported in a separate liability account.
The ALL is a major factor in the evaluation of an institution's ability to absorb credit losses, the fairness and accuracy of its financial statements and its safety and soundness. The ALL is a contra account recorded as an offset to (i.e., a reduction in) the amount of loans on the institution's balance sheet. The adequacy of the ALL is driven by effective board policy and oversight, a well documented analysis of individual loan and portfolio risk factors, and timely risk identification. This Examination Manual section is designed to give examiners the tools to effectively evaluate the board and management’s documentation and determination of the institution’s allowance needs.
Requirements and Authority
FCA regulation, § 621.3 - Application of Generally Accepted Accounting Principles, requires System institutions to prepare and maintain financial statements in accordance with GAAP. In addition, FCA regulation § 621.5 - Accounting For The Allowance For Loan Losses And Charge-Offs, requires that institutions maintain at all times an allowance for loan losses that is determined in accordance with GAAP.
GAAP requires the accrual of a loss contingency (establishment of an allowance via a charge to earnings through the provision for losses) when information available prior to the issuance of the financial statements indicates it is probable that an asset has been impaired at the date of the financial statements and the amount of loss can be reasonably estimated. An individual loan is impaired when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The primary pronouncements under GAAP that address the establishment and maintenance of the ALL are Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies" (SFAS 5); SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" (SFAS 114); and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan--Income Recognition and Disclosure" (SFAS 118), which amended SFAS 114. SFAS 5 provides the general principles a creditor should apply to account for impairment in the loan portfolio and SFAS 114 deals primarily with the requirements for a specific ALL on individual loans determined to be impaired. Other interpretive guidance, best practices and regulatory guidance are also found in:
§ Emerging Issues Task Force Topic No. D-80, Application of FASB Statements No. 5 and No. 114 to a Loan Portfolio;
§ FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34;
§ Federal Banking Agencies – December 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses;
§ Federal Banking Agencies – December 2006 Questions and Answers on Accounting for Loan and Lease Losses;
§ FCA Bookletter BL-049 dated April 26, 2004, Adequacy of Farm Credit System Institutions' Allowance for Loan Losses and Risk Funds;
§ FCA Informational Memorandum dated April 26, 2004, Allowance for Loan Losses; and,
§ SR 06-17 – Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL).
Determining the Amount of the Allowance
Quarterly, or more frequently if warranted, each institution shall analyze the collectibility of all loans in its portfolio using the criteria and requirements of SFAS 5 and SFAS 114 and maintain an ALL at an appropriate level to cover estimated probable loan losses that exist at the date of the financial statements. Estimates of credit losses should reflect consideration of all significant factors that affect the collectibility of the portfolio as of the evaluation date. The bases of these estimates should not be limited to the institution’s historical loss experience, but also include judgmental and forward-looking factors such as the likely impact of key economic indicators. However, documentation of the application of such judgmental factors is critical. Under GAAP, the purpose of the ALL is not to absorb all of the risk in the loan portfolio, but to cover probable credit losses that may have already been incurred.
Increases to the ALL are made through the provision for loan losses, which is an expense account and results in a reduction of earnings. Reversals to the ALL, a negative provision, have the effect of increasing an institution’s earnings. Increases to the ALL also happen when an institution records a recovery of a previously charged-off loan. When the periodic analysis of the ALL concludes that the ALL requirement is less than the current balance in the ALL, a reversal to the ALL may be warranted. Also, when a loan is charged-off as probable losses become known, the charge-off reduces the balance of the ALL account as well as the loan account.
SFAS 114--Under SFAS 114, an individual loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts (principal and interest) due according to the contractual terms of the loan agreement. SFAS 114 does not specify how an institution should identify loans that are to be evaluated for collectibility nor does it specify how an institution should determine that a loan is impaired. Loans selected to be evaluated for impairment should be based on the institution’s criteria and policy. An institution should apply its normal loan review procedures in making those judgments. Generally, System institutions classify nonaccrual loans, restructured accrual loans and loans 90 days or more past due as impaired loans.
A loan selected for individual evaluation within the scope of SFAS 114, may or may not be impaired. If loans within the scope of SFAS 114 are impaired, the associated specific ALL should be based upon one of the standard’s three impairment measurement methods as of the evaluation date:
§ the present value of expected future cash flows discounted at the loan’s effective interest rate,
§ the loan’s observable market price, or
§ the fair value of the collateral if the loan is collateral dependent.
Generally, a measurement method will be selected on a loan-by-loan basis. However, when the creditor determines that foreclosure is probable, measurement must be based on the fair value of the collateral.
The amount of the specific ALL is the difference between the loan exposure and the amount expected to be recovered. The amount of the specific ALL for the impaired loan should not be supplemented by any general ALL determined in accordance with SFAS 5. Also, even if the evaluation of the impaired loan determined that no specific ALL was required, the loan should not be included in the process for determining the general ALL.
The relationship between risk ratings, the uniform classification system and impaired assets do not reconcile directly. An individual loan is impaired when it is probable not all amounts due will be collected according to the terms and conditions of the loan agreement. Therefore, loans which are substandard or doubtful and in nonaccrual status are usually considered impaired because there is doubt regarding full collection of all principal and interest from operating sources, and therefore, liquidation of collateral is likely the only recourse for repayment. However, loans that are classified substandard based on well defined weaknesses in operation but the borrower is projected to be able to service the debt from ongoing operations would not meet the definition of impairment under SFAS 114 and thus should remain in the general ALL pool. There is also no direct correlation of GAAP impairment to the 14-point risk rating system, although the line between unimpaired and impaired assets would likely be between risk rating 11, substandard viable loans and risk rating 12, substandard nonviable loans. Another important point is that the specific allowance amount does not have to equal any particular classification or risk rating category. For example, a loan that is risk rated 12, substandard nonviable, nonaccrual in the amount of $100,000 with only $90,000 of collateral and $1,000 estimated costs to sell, should have a specific allowance of $11,000. Since this is a collateral dependent loan, the fair value is the collateral value less the selling costs. In this case, neither the loan nor the specific allowance amount would need to be classified doubtful.
SFAS 5--SFAS 5 requires the accrual of a loss contingency when information available prior to the issuance of the financial statements indicates it is probable that an asset has been impaired at the date of the financial statements and the amount of loss can be reasonably estimated. These conditions may be considered in relation to individual loans or by segmenting the portfolio into groups of loans with similar risk characteristics and should be supplemented with estimates of losses associated with the general economic environment. While it is highly improbable for an institution to review each loan individually, most institutions segment those loans into pools with common risk characteristics and evaluate the estimated probable losses based on each pool. Also, any loan that was identified for evaluation under SFAS 114 and was determined to not be impaired should be grouped with other loans that share common characteristics for evaluation in accordance with the requirements of SFAS 5. The basis for segmenting loans into groups of loans with common characteristics should be determined by the institution, consistently applied and fully documented.
The validity of the ALL for a pool of loans is based on an accurate and reliable credit review system, reasonable loss factors (discussed below), and documentation supporting the process and assumptions used. An effective loan review system is a valuable control that helps ensure the accuracy of internal credit classification or grading systems and, the quality of the information used to determine the appropriate level of the ALL. The level of ALL for the pool of loans should be based on the loss factors that reflect the institution’s historical charge-off experience adjusted for current economic conditions applied to loan groups with similar characteristics or classifications in the current portfolio. There may be times when an institution does not have its own historical loss experience upon which to base its estimate of the credit losses in a group of loans with similar risk characteristics. If an institution has no experience of its own for a loan group, reference to the experience of other enterprises in the same lending business may be appropriate, provided the institution demonstrates that the attributes of the group of loans in its portfolio are similar to those of the loan group in the portfolio providing the loss experience. This however, should only be used until it has developed its own loss experience for a particular group of loans. Regardless of the source of the loss factors used and the changes made, the institution should have documentation and work papers to support the origin of the loss factors. Loss history, in and of itself, should not be the basis for determining the appropriate level of the allowance.
System institutions use a 14-point risk classification system to classify loans and this typically is the foundation of the model for determining the adequacy of the general ALL. Loans with a classification from 1 through 11 are generally included in the universe for determining the amount of the general ALL. Loans classified 12 and higher are generally evaluated for specific impairment in accordance with SFAS 114. The general ALL is based on a dual approach that considers the probability that the borrower will default (Probability of Default (PD)) and the estimate of the loss on the loan assuming that a borrower does default (Loss Given Default (LGD)). These loss factors are determined for each credit classification and are applied to the loan exposure for each loan’s classification to determine the amount of the ALL. The PD is borrower specific and is the probability that a specific borrower will default on an obligation. The LGD is the estimated loss to be incurred based on the collateral position of the loan. It is essential that management accurately classify their portfolio to ensure that the risk is appropriately considered and the model reflects an adequate amount of general allowance in relation to portfolio risk.
Because an institution’s historical loss experience will not include the impact of the current economic environment, management must be diligent in evaluating the impact that current economic events or other events will have on the historical factors used to evaluate the adequacy of the ALL. In determining the adequacy of the ALL, management and institution boards must consider the unique and varied concentrations in its portfolio—such as:
§ Levels and trends in delinquent, non-performing, non-accrual and impaired loans;
§ Levels and trends in charge-offs and recoveries;
§ Trends in volume and terms of loans;
§ Effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures and practices;
§ National and local economic trends and conditions;
§ Experience and ability of lending officers, credit review and other applicable staff;
§ Industry/commodity and cash flows conditions profitability;
§ Effects of changes in credit concentrations; and,
§ Trends in collateral values.
The analysis of current economic conditions will result in adjustments to the formula driven ALL which relies primarily on historical loss experience. It can be incorporated into the ALL analysis by adjusting the PD and LGD factors, but is more likely identified as an industry specific or event specific ALL adjustment. Failure to fully consider and document the current economic conditions into the process could result in an inaccurate allowance and could be considered an unsafe and unsound practice.
The total general ALL for the institution is the sum of the general ALL required for each pool plus any adjustments for current economic conditions. The ALL requirement for the entire portfolio is the sum of the ALL provided for specific loans under SFAS 114 and the general ALL determined in accordance with SFAS 5. However, even though the ALL is based on the sum of two separate evaluations, the ALL is available to cover all charge-offs that arise from the loan portfolio.
It is not appropriate to supplement the ALL with amounts not documented or determined in accordance with GAAP. However, determining the appropriate level for the ALL requires a high degree of management judgment. When a range of losses is determined, institutions should maintain appropriate documentation to support the identified range and the rationale used for determining the best estimate from within the range of loan losses. A component of the ALL that is labeled “unallocated” is appropriate when it reflects estimated credit losses determined in accordance with GAAP and is properly supported and documented. It is not appropriate for any portion of the ALL to be based on predetermined percentages or amounts.
If the ALL required by the current periodic review is different than the amount of the ALL recorded in the institutions financial statements, the financial statements should be adjusted accordingly in the quarter the required ALL is identified. This will be either through a reduction to earnings if a provision for loans losses is required to increase the ALL, or an increase to earnings if a negative provision for loan losses is required to reduce the ALL. The decision to adjust the ALL to the required level is not dependent on the earnings or the capital level of the institution, but on the need to adjust the ALL to the proper amount to provide for estimated losses that exist in the loan portfolio at the date of the financial statements. Regardless of the earnings level, not adjusting the ALL to comply with GAAP is a violation of FCA regulations.
Board and Management and Responsibilities
Each System board of directors is responsible for ensuring that its institution has controls in place to consistently determine the ALL in accordance with regulatory requirements, the institution’s policies, and GAAP. To fulfill this responsibility, the board of directors must have policies directing management to develop, document and maintain an appropriate, systematic, and consistently applied process to ensure that the provision for losses and the ALL are adequate and fully supported.
Management should create and implement suitable policies and procedures to communicate the ALL process internally to all applicable personnel. Additionally, by creating an environment that encourages personnel to follow these policies and procedures, management improves procedural discipline and compliance. The determination of the amount of the ALL and provision for loan losses should be based on management’s judgment about the current risk of the loan portfolio, and should consider all relevant internal and external factors that affect loan and lease collectibility as of the reporting date.
The amounts to be reported each period for the provision for loan losses and the ALL should be reviewed by the board of directors. To ensure the methodology remains appropriate, the board of directors should have the methodology periodically validated and, if appropriate, revised. The board of directors should ensure that policies specifically address the institution’s unique goals, systems, risk profile, personnel, and other resources before approving them. Further, the board should oversee and monitor the internal controls over the ALL determination process.
FCA regulatory guidance requires compliance with GAAP and requires the ALL process to be well documented, with clear explanations of the supporting analyses and rationale. This guidance applies equally to all System institutions, regardless of asset size. However, System institutions with less complex lending activities and products may find it more efficient to combine a number of procedures (e.g., information gathering, documentation, and internal approval processes) while continuing to ensure the institution has a consistent and appropriate methodology.
Appropriate written supporting documentation contributes to the control environment, builds discipline and consistency into the ALL determination process, and improves the process for estimating loan losses by helping to ensure that all relevant factors are appropriately considered in the ALL analysis. An institution should document the relationship between the findings of its detailed review of the loan portfolio and the amount of the ALL and the provision for loan losses reported in each period. On a periodic basis, boards and management should evaluate the accuracy of their process to estimate losses and adjust calculation factors and models accordingly. At a minimum, System institutions should maintain written supporting documentation for the following areas:
1. Policies and procedures over the:
2. Loan grading system or process.
a. Systems and controls that maintain an appropriate ALL,
b. Criteria for recording charge-offs, and
c. ALL methodology and specific factors used in calculations.
3. The ALL analysis and support for recommended provisions.
4. Validation or testing of the ALL methodology.
5. Periodic adjustments to the ALL process.
Failure to document, maintain, analyze, or support an adequate ALL in accordance with GAAP and regulatory guidance is an unsafe and unsound practice.
The examiner should determine the reasonableness of an institution’s recorded ALL by ensuring the methodology is logical, appropriate, consistently applied and meets the requirements of FCA regulations and GAAP. If the examiner concludes that the reported ALL is not appropriate or that the evaluation process is deficient, these concerns, along with corrective actions, should be noted in the report of examination. The examiner’s comments should cite any departures from GAAP and FCA regulations.
§ Determine if the board provides effective oversight and policy direction over the ALL process.
§ Determine if the institution's methodology considers all risk factors and is logical, appropriate, consistently applied and meets the requirements of FCA regulations and GAAP.
§ Determine the reasonableness of the institution’s recorded ALL.
§ Ensure the examination of the ALL considers the examination results and conditions of other operational areas of an institution. This will require coordination with examiners reviewing lending policies, loan portfolio management, internal credit review processes, business planning or other areas which may provide information on loss exposure and the adequacy of the ALL.
§ Conclude on the adequacy of the ALL and the ALL process. If the examiner concludes that the ALL level is not appropriate or determines that the evaluation process is based on the results of an unreliable loan review system, recommendations for correcting these deficiencies, should be noted in the report of examination and likely is an unsafe and unsound condition.
The following procedures provide a benchmark process (or basic model) for evaluating the adequacy of the ALL. Emphasis should be on identifying how examination results, conditions and controls in other areas impact the ALL, and ensuring sufficient work is done to conclude on the adequacy of the ALL amount and the processes used by management to determine the amount. In accordance with the Office of Examination’s risk based examination philosophy, the EIC should adjust the scope of each examination as deemed necessary based on the risk and particular circumstances of the institution. The EIC should adjust the scope of each examination as deemed necessary based on the risk and particular circumstances of the institution.
In reviewing the appropriateness of the ALL, examiners should:
§ Consider the effectiveness of board oversight of the ALL process as well as the quality of the institution’s loan review system and management in identifying, monitoring, and addressing asset quality problems. This will include a review of the institution’s loan review function and credit grading system. Typically, this will involve testing a sample of the institution’s loans. The sample size generally varies and will depend on the nature or purpose of the examination.
§ Evaluate the institution’s ALL policies and procedures and assess the methodology that management uses to arrive at an estimate of the ALL, including whether management’s assumptions, valuations, and judgments appear reasonable and are properly supported. If a range of credit losses has been estimated by management, evaluate the reasonableness of management’s best estimate within the range. In making these evaluations, examiners should ensure that the institution’s historical loss experience and all significant qualitative or environmental factors that affect the collectibility of the portfolio have been appropriately considered and that management has appropriately applied GAAP, including SFAS 114 and SFAS 5.
§ Review the institutions processes and procedures for determining and measuring impairment under SFAS 114:
a) Determine how loans are identified for evaluation of impairment.
b) Determine which of the three impairment measurement methods are being used to evaluate impairment. Keeping in mind when the creditor determines that foreclosure is probable, measurement must be based on the fair value of the collateral less costs to sell.
c) Test a sample of loans identified as impaired to ensure the calculations are appropriate;
d) Determine how loans individually evaluated under SFAS 114, but not considered to be individually impaired, are grouped with other loans that share common characteristics for impairment evaluation under SFAS 5.
§ Review the institutions processes and procedures for determining and measuring impairment under SFAS 5. Determine:
§ How loans with similar characteristics are grouped to be evaluated for loan collectibility (such as loan type, past-due status, and risk);
§ How loss rates are determined and what factors are used to validate the accuracy of PDs and LGDs;
a) How qualitative factors (e.g., industry, geographical, economic and political factors) that may affect loss rates or other loss measurements;
b) How current economic and credit conditions and trends are factored into the general ALL. For example, factors to consider in determining amounts to supplement the historical loss factors are:
o Levels and trends in delinquencies non-performing, non-accrual, and impaired loans;
o Levels and trends in charge-offs and recoveries;
o Trends in volume and terms of loans;
o Effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures and practices;
o National and local economic trends and conditions;
o Experience, ability, and depth of lending officers and relevant staff;
o Industry/commodity and cash flows conditions profitability;
o Effects of changes in credit concentrations; and,
o Trends in collateral values.
§ Review management’s use of loss estimation models or other loss estimation tools to ensure that the resulting estimated credit losses are in conformity with GAAP. If any portion of the ALL is designated “unallocated”, ensure it reflects estimated credit losses determined in accordance with GAAP and is properly supported and documented. Economic considerations for the geographic territory served, portfolio concentrations in industries experiencing stress, weakness in underlying loan underwriting or scorecard programs could all be reasons an institution determines an unallocated reserve is necessary. It is not appropriate for the ‘unallocated” portion or any portion of the ALL to be based on predetermined percentages or amounts.
§ Review the appropriateness and reasonableness of the overall level of the ALL. In some instances this may include a quantitative analysis and comparison to peers and prior periods as a preliminary check. This quantitative analysis should determine whether changes in the key ratios from prior periods are reasonable based on the examiner’s knowledge of the collectibility of loans at the institution and its current environment. If the institution has made significant adjustments to the ALL, review the institution's documentation to determine if management clearly determined that the events giving rise to the significant change occurred in the current period and not in prior periods. If changes should have been made in prior periods and are material, consider whether the institution needs to re-disclose to shareholders, or re-issue Call Reports.
§ Review the ALL amount reported in the institution’s regulatory reports and financial statements and ensure these amounts reconcile to its ALL analyses and the institution’s general ledger accounts. There should be no material differences between the amount of the ALL calculated by the institution’s ALL methodology, and the final ALL balance reported in the financial statements.
§ Review the adequacy of the documentation and controls maintained by management to support the appropriateness of the ALL. Ensure the appropriate members of the institution’s management, and if applicable the ALL Committee, the Audit Committee and the board of directors have approved the allowance process and amounts.
§ Validate examination findings in an exit conference with appropriate institutional management. Obtain management's response to the underlying cause(s) of deficiencies or weaknesses, as well as management's planned corrective actions.
§ Based on the procedures completed above, conclude on whether the institutions ALL methodology is logical, appropriate, and consistently applied, and that the recorded ALL is reasonable and in compliance with GAAP and FCA regulations.
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