ALLOWANCE FOR LOAN AND LEASE LOSSES—Interagency Policy Statement¹

The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision, jointly with the National Credit Union Administration, have revised the banking agencies’ 1993 policy statement on the allowance for loan and lease losses (ALLL) to ensure consistency with generally accepted accounting principles (GAAP) and more recent supervisory guidance. The banking agencies originally issued the 1993 policy statement to describe the responsibilities of the boards of directors and management of banks and savings associations and of examiners regarding the ALLL. This revision replaces the 1993 policy statement and also makes it applicable to credit unions. In addition, the agencies are issuing the attached frequently asked questions (FAQs) to assist institutions in complying with GAAP and ALLL supervisory guidance.

This policy statement reiterates key concepts and requirements included in GAAP and existing ALLL supervisory guidance.²

The principal sources of guidance on accounting for impairment in a loan portfolio under GAAP are Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (FAS 5), and Statement of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan” (FAS 114). In addition, the Financial Accounting Standards Board Viewpoints article that is included in Emerging Issues Task Force Topic D-80 (EITF D-80), “Application of FASB Statements No. 5 and No. 114 to a Loan Portfolio,” presents questions and answers that provide specific guidance on the interaction between these two FASB statements and may be helpful in applying them.

In July 1999, the banking agencies and the Securities and Exchange Commission (SEC) issued a joint interagency letter to financial institutions. The letter stated that the banking agencies and the SEC agreed on the following important aspects of loan loss allowance practices:

In July 2001, the banking agencies issued a Policy Statement on Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions (2001 policy statement) (at 3-1484). It is designed to assist institutions in establishing a sound process for determining an appropriate ALLL and documenting that process in accordance with GAAP.³ The guidance in the 2001 policy statement was substantially adopted by the NCUA through its Interpretative Ruling and Policy Statement 02-3, “Allowance for Loan and Lease Losses Methodologies and Documentation for Federally Insured Credit Unions” in May 2002 (NCUA’s 2002 IRPS).

In March 2004, the agencies issued an update on accounting for loan and lease losses. This guidance provided reminders of longstanding supervisory guidance as well as a listing of the existing allowance guidance that institutions should continue to apply.

The ALLL represents one of the most significant estimates in an institution’s financial statements and regulatory reports. Because of its significance, each institution has a responsibility for developing, maintaining, and documenting a comprehensive, systematic, and consistently applied process for determining the amounts of the ALLL and the provision for loan and lease losses (PLLL). To fulfill this responsibility, each institution should ensure controls are in place to consistently determine the ALLL in accordance with GAAP, the institution’s stated policies and procedures, management’s best judgment and relevant supervisory guidance.

As of the end of each quarter, or more frequently if warranted, each institution must analyze the collectibility of its loans and leases held for investment⁴ (hereafter referred to as “loans”) and maintain an ALLL at a level that is appropriate and determined in accordance with GAAP. An appropriate ALLL covers estimated credit losses on individually evaluated loans that are determined to be impaired as well as estimated credit losses inherent in the remainder of the loan and lease portfolio. The ALLL does not apply, however, to loans carried at fair value, loans held for sale,⁵ off-balance-sheet credit exposures⁶ (e.g., financial instruments such as off-balance-sheet loan commitments, standby letters of credit, and guarantees), or general or unspecified business risks.

For purposes of this policy statement, the term estimated credit losses means an estimate of the current amount of loans that it is probable the institution will be unable to collect given facts and circumstances as of the evaluation date. Thus, estimated credit losses represent net charge-offs that are likely to be realized for a loan or group of loans. These estimated credit losses should meet the criteria for accrual of a loss contingency (i.e., through a provision to the ALLL) set forth in GAAP.⁷ When available information confirms that specific loans, or portions thereof, are uncollectible, these amounts should be promptly charged off against the ALLL.

For “purchased impaired loans,”⁸ GAAP prohibits “carrying over” or creating an ALLL in the initial recording of these loans. However, if, upon evaluation subsequent to acquisition, it is probable that the institution will be unable to collect all cash flows expected at acquisition on a purchased impaired loan (an estimate that considers both timing and amount), the loan should be considered impaired for purposes of applying the measurement and other provisions of FAS 5 or, if applicable, FAS 114.

Estimates of credit losses should reflect consideration of all significant factors that affect the collectibility of the portfolio as of the evaluation date. For loans within the scope of FAS 114 that are individually evaluated and determined to be impaired,⁹ these estimates should reflect consideration of one of the standard’s three impairment-measurement methods as of the evaluation date: (1) the present value of expected future cash flows discounted at the loan’s effective interest rate,¹⁰ (2) the loan’s observable market price, or (3) the fair value of the collateral if the loan is collateral dependent.

An institution may choose the appropriate FAS 114 measurement method on a loan-by-loan basis for an individually impaired loan, except for an impaired collateral-dependent loan. The agencies require impairment of a collateral-dependent loan to be measured using the fair value of collateral method. As defined in FAS 114, a loan is collateral dependent if repayment of the loan is expected to be provided solely by the underlying collateral. In general, any portion of the recorded investment in a collateral-dependent loan (including any capitalized accrued interest, net deferred loan fees or costs, and unamortized premium or discount) in excess of the fair value of the collateral that can be identified as uncollectible, and is therefore deemed a confirmed loss, should be promptly charged off against the ALLL.¹¹

All other loans, including individually evaluated loans determined not to be impaired under FAS 114, should be included in a group of loans that is evaluated for impairment under FAS 5.¹² While an institution may segment its loan portfolio into groups of loans based on a variety of factors, the loans within each group should have similar risk characteristics. For example, a loan that is fully collateralized with risk-free assets should not be grouped with uncollateralized loans. When estimating credit losses on each group of loans with similar risk characteristics, an institution should consider its historical loss experience on the group, adjusted for changes in trends, conditions, and other relevant factors that affect repayment of the loans as of the evaluation date.

For analytical purposes, an institution should attribute portions of the ALLL to loans that it evaluates and determines to be impaired under FAS 114 and to groups of loans that it evaluates collectively under FAS 5. However, the ALLL is available to cover all charge-offs that arise from the loan portfolio.

Each institution’s management is responsible for maintaining the ALLL at an appropriate level and for documenting its analysis according to the standards set forth in the 2001 policy statement (at 3-1484) or the NCUA’s 2002 IRPS, as applicable. Thus, management should evaluate the ALLL reported on the balance sheet as of the end of each quarter (and for credit unions, prior to paying dividends), or more frequently if warranted, and charge or credit the PLLL to bring the ALLL to an appropriate level as of each evaluation date. The determination of the amounts of the ALLL and the PLLL should be based on management’s current judgments about the credit quality of the loan portfolio, and should consider all known relevant internal and external factors that affect loan collectibility as of the evaluation date. Management’s evaluation is subject to review by examiners. An institution’s failure to analyze the collectibility of the loan portfolio and maintain and support an appropriate ALLL in accordance with GAAP and supervisory guidance is generally an unsafe and unsound practice.

In carrying out its responsibility for maintaining an appropriate ALLL, management is expected to adopt and adhere to written policies and procedures that are appropriate to the size of the institution and the nature, scope, and risk of its lending activities. At a minimum, these policies and procedures should ensure the following:

The board of directors is responsible for overseeing management’s significant judgments and estimates pertaining to the determination of an appropriate ALLL. This oversight should include but is not limited to—

For purposes of the Reports of Condition and Income (call report), the Thrift Financial Report (TFR), and the NCUA Call Report (5300), an appropriate ALLL (after deducting all loans and portions of loans confirmed loss) should consist only of the following components (as applicable),¹⁵ the amounts of which take into account all relevant facts and circumstances as of the evaluation date:

Because deposit accounts that are overdrawn (i.e., overdrafts) must be reclassified as loans on the balance sheet, overdrawn accounts should be included in one of the first two components above, as appropriate, and evaluated for estimated credit losses.

Determining the appropriate level for the ALLL is inevitably imprecise and requires a high degree of management judgment. Management’s analysis should reflect a prudent, conservative, but not excessive ALLL that falls within an acceptable range of estimated credit losses. 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.

As discussed more fully in attachment 1, it is essential that institutions maintain effective loan-review systems. An effective loan-review system should work to ensure the accuracy of internal credit-classification or -grading systems and, thus, the quality of the information used to assess the appropriateness of the ALLL. The complexity and scope of an institution’s ALLL evaluation process, loan-review system, and other relevant controls should be appropriate for the size of the institution and the nature of its lending activities. The evaluation process should also provide for sufficient flexibility to respond to changes in the factors that affect the collectibility of the portfolio.

Credit losses that arise from the transfer risk associated with an institution’s cross-border lending activities require special consideration. In particular, for banks with cross-border lending exposure, management should determine that the ALLL is appropriate to cover estimated losses from transfer risk associated with this exposure over and above any minimum amount that the Interagency Country Exposure Review Committee requires to be provided in the allocated transfer risk reserve (or charged off against the ALLL). These estimated losses should meet the criteria for accrual of a loss contingency set forth in GAAP. (See attachment 2 for factors to consider.)

Estimated credit losses should reflect consideration of all significant factors that affect the collectibility of the portfolio as of the evaluation date. Normally, an institution should determine the historical loss rate for each group of loans with similar risk characteristics in its portfolio based on its own loss experience for loans in that group. While historical loss experience provides a reasonable starting point for the institution’s analysis, historical losses, or even recent trends in losses, do not by themselves form a sufficient basis to determine the appropriate level for the ALLL. Management should also consider those qualitative or environmental factors that are likely to cause estimated credit losses associated with the institution’s existing portfolio to differ from historical loss experience, including but not limited to—

In addition, changes in the level of the ALLL should be directionally consistent with changes in the factors, taken as a whole, that evidence credit losses, keeping in mind the characteristics of an institution’s loan portfolio. For example, if declining credit-quality trends relevant to the types of loans in an institution’s portfolio are evident, the ALLL level as a percentage of the portfolio should generally increase, barring unusual charge-off activity. Similarly, if improving credit-quality trends are evident, the ALLL level as a percentage of the portfolio should generally decrease.

FAS 5. When measuring estimated credit losses on groups of loans with similar risk characteristics in accordance with FAS 5, a widely used method is based on each group’s historical net charge-off rate adjusted for the effects of the qualitative or environmental factors discussed previously. As the first step in applying this method, management generally bases the historical net charge-off rates on the “annualized” historical gross loan charge-offs, less recoveries, recorded by the institution on loans in each group.

Methodologies for determining the historical net charge-off rate on a group of loans with similar risk characteristics under FAS 5 can range from the simple average of, or a determination of the range of, an institution’s annual net charge-off experience to more-complex techniques, such as migration analysis and models that estimate credit losses.²⁰ Generally, institutions should use at least an “annualized” or 12-month average net charge-off rate that will be applied to the groups of loans when estimating credit losses. However, this rate could vary. For example, loans with effective lives longer than 12 months often have workout periods over an extended period of time, which may indicate that the estimated credit losses should be greater than that calculated based solely on the annualized net charge-off rate for such loans. These groups may include certain commercial loans as well as groups of adversely classified loans. Other groups of loans may have effective lives shorter than 12 months, which may indicate that the estimated credit losses should be less than that calculated based on the annualized net charge-off rate.

Regardless of the method used, institutions should maintain supporting documentation for the techniques used to develop the historical loss rate for each group of loans. If a range of historical loss rates is developed instead for a group of loans, institutions should maintain documentation to support the identified range and the rationale for determining which rate is the best estimate within the range of loss rates. The rationale should be based on management’s assessment of which rate is most reflective of the estimated credit losses in the current loan portfolio.

After determining the appropriate historical loss rate for each group of loans with similar risk characteristics, management should consider those current qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the group’s historical loss experience. Institutions typically reflect the overall effect of these factors on a loan group as an adjustment that, as appropriate, increases or decreases the historical loss rate applied to the loan group. Alternatively, the effect of these factors may be reflected through separate standalone adjustments within the FAS 5 component of the ALLL.²¹ Both methods are consistent with GAAP provided the adjustments for qualitative or environmental factors are reasonably and consistently determined, are adequately documented, and represent estimated credit losses. For each group of loans, an institution should apply its adjusted historical loss rate, or its historical loss rate and separate standalone adjustments, to the recorded investment in the group when determining its estimated credit losses.

Management must exercise significant judgment when evaluating the effect of qualitative factors on the amount of the ALLL because data may not be reasonably available or directly applicable for management to determine the precise impact of a factor on the collectibility of the institution’s loan portfolio as of the evaluation date. Accordingly, institutions should support adjustments to historical loss rates and explain how the adjustments reflect current information, events, circumstances, and conditions in the loss measurements. Management should maintain reasonable documentation to support which factors affected the analysis and the impact of those factors on the loss measurement. Support and documentation includes descriptions of each factor, management’s analysis of how each factor has changed over time, which loan groups’ loss rates have been adjusted, the amount by which loss estimates have been adjusted for changes in conditions, an explanation of how management estimated the impact, and other available data that supports the reasonableness of the adjustments. Examples of underlying supporting evidence could include, but are not limited to, relevant articles from newspapers and other publications that describe economic events affecting a particular geographic area, economic reports and data, and notes from discussions with borrowers.

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. This may occur when an institution offers a new loan product or in the case of a newly established (i.e., de novo) institution. 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. An institution should only use another enterprise’s experience on a short-term basis until it has developed its own loss experience for a particular group of loans.

FAS 114. When determining the FAS 114 component of the ALLL for an individually impaired loan,²² an institution should consider estimated costs to sell the loan’s collateral, if any, on a discounted basis, in the measurement of impairment if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan. If the institution bases its measure of loan impairment on the present value of expected future cash flows discounted at the loan’s effective interest rate, the estimates of these cash flows should be the institution’s best estimate based on reasonable and supportable assumptions and projections. All available evidence should be considered in developing the estimate of expected future cash flows. The weight given to the evidence should be commensurate with the extent to which the evidence can be verified objectively. The likelihood of the possible outcomes should be considered in determining the best estimate of expected future cash flows.

Institutions are also encouraged to use ratio analysis as a supplemental tool for evaluating the overall reasonableness of the ALLL. Ratio analysis can be useful in identifying divergent trends (compared with an institution’s peer group and its own historical experience) in the relationship of the ALLL to adversely classified or graded loans, past-due and nonaccrual loans, total loans, and historical gross and net charge-offs. Based on such analysis, an institution may identify additional issues or factors that previously had not been considered in the ALLL estimation process, which may warrant adjustments to estimated credit losses. Such adjustments should be appropriately supported and documented.

While ratio analysis, when used prudently, can be helpful as a supplemental check on the reasonableness of management’s assumptions and analyses, it is not a sufficient basis for determining the appropriate amount for the ALLL. In particular, because an appropriate ALLL is an institution-specific amount, such comparisons do not obviate the need for a comprehensive analysis of the loan portfolio and the factors affecting its collectibility. Furthermore, it is inappropriate for the board of directors or management to make adjustments to the ALLL when it has been properly computed and supported under the institution’s methodology for the sole purpose of reporting an ALLL that corresponds to the peer group median, a target ratio, or a budgeted amount. Institutions that have high levels of risk in the loan portfolio or are uncertain about the effect of possible future events on the collectibility of the portfolio should address these concerns by maintaining higher equity capital and not by arbitrarily increasing the ALLL in excess of amounts supported under GAAP.²³

Estimated credit losses in credit-related accounts. Typically, institutions evaluate and estimate credit losses for off-balance-sheet credit exposures at the same time that they estimate credit losses for loans. While a similar process should be followed to support loss estimates related to off-balance-sheet exposures, these estimated credit losses are not recorded as part of the ALLL. When the conditions for accrual of a loss under FAS 5 are met, an institution should maintain and report as a separate liability account, an allowance that is appropriate to cover estimated credit losses on off-balance-sheet loan commitments, standby letters of credit, and guarantees. In addition, recourse liability accounts (that arise from recourse obligations on any transfers of loans that are reported as sales in accordance with GAAP) should be reported in regulatory reports as liabilities that are separate and distinct from both the ALLL and the allowance for credit losses on off-balance-sheet credit exposures.

When accrued interest and fees are reported separately on an institution’s balance sheet from the related loan balances (i.e., as other assets), the institution should maintain an appropriate valuation allowance, determined in accordance with GAAP, for amounts that are not likely to be collected unless management has placed the underlying loans in nonaccrual status and reversed previously accrued interest and fees.²⁴

Examiners should assess the credit quality of an institution’s loan portfolio, the appropriateness of its ALLL methodology and documentation, and the appropriateness of the reported ALLL in the institution’s regulatory reports. In their review and classification or grading of the loan portfolio, examiners should consider all significant factors that affect the collectibility of the portfolio, including the value of any collateral. In reviewing the appropriateness of the ALLL, examiners should—

As noted in the “Responsibilities of the Board of Directors and Management” section of this policy statement, when assessing the appropriateness of the ALLL, it is important to recognize that the related process, methodology, and underlying assumptions require a substantial degree of management judgment. Even when an institution maintains sound loan-administration and collection procedures and an effective loan-review system and controls, its estimate of credit losses is not a single precise amount due to the wide range of qualitative or environmental factors that must be considered.

An institution’s ability to estimate credit losses on specific loans and groups of loans should improve over time as substantive information accumulates regarding the factors affecting repayment prospects. Therefore, examiners should generally accept management’s estimates when they assess the appropriateness of the institution’s reported ALLL, and not seek adjustments to the ALLL, when management has—

If the examiner concludes that the reported ALLL level is not appropriate or determines that the ALLL evaluation process is based on the results of an unreliable loan-review system or is otherwise deficient, recommendations for correcting these deficiencies, including any examiner concerns regarding an appropriate level for the ALLL, should be noted in the report of examination. The examiner’s comments should cite any departures from GAAP and any contraventions of this policy statement and the 2001 policy statement (at 3-1484) or the NCUA’s 2002 IRPS, as applicable. Additional supervisory action may also be taken based on the magnitude of the observed shortcomings in the ALLL process, including the materiality of any error in the reported amount of the ALLL.

The agencies believe that an ALLL established in accordance with this policy statement and the 2001 policy statement or the NCUA’s 2002 IRPS, as applicable, falls within the range of acceptable estimates determined in accordance with GAAP. When the reported amount of an institution’s ALLL is not appropriate, the institution will be required to adjust its ALLL by an amount sufficient to bring the ALLL reported on its call report, TFR, or 5300 to an appropriate level as of the evaluation date. This adjustment should be reflected in the current-period provision or through the restatement of prior-period provisions, as appropriate in the circumstances.

The agencies do not intend this policy statement and the FAQs to create any new information collection requirements under the Paperwork Reduction Act. To the extent this policy statement and the FAQs involve information collection requirements, they are already required by GAAP or existing informa tion collections for which the agencies have jointly or individually received approval.

With respect to international transfer risk, an institution with cross-border exposures should support its determination of the appropriateness of its ALLL by performing an analysis of the transfer risk, commensurate with the size and composition of the institution’s exposure to each country. Such analyses should take into consideration the following factors, as appropriate: