Allowance for Loan and Lease Losses for Banks

It is the responsibility of a bank to maintain an Allowance for Loan and Lease Losses (ALLL) that is consistent with Generally Accepted Accounting Principles (GAAP) and the Interagency Policy Statement on the Allowance for Loan and lease Losses.   The bank’s ALLL policy provides for the following:

• A documented, comprehensive, systematic and consistently applied process for determining the amounts of the ALLL and the provision for loan and lease losses (PLLL).
• Controls that consistently determine the ALLL in accordance with; GAAP, this policy, management’s best judgment and relevant supervisory guidance.

Important Aspects of the Loan Loss Allowance

• Arriving at an appropriate allowance involves a high degree of management judgment and results in a range of estimated losses;

• Prudent, conservative, but not excessive, loan loss allowances that fall within an

acceptable range of estimated losses is appropriate. In accordance with GAAP,            an institution should record its best estimate within the range of credit losses,     including when management’s best estimate is at the high end of the range;

• An “unallocated” loan loss allowance is appropriate when it reflects an estimate of probable losses, determined in accordance with GAAP, and is properly supported;

• Determining the allowance for loan losses is inevitably imprecise, and an appropriate allowance falls within a range of estimated losses;

• Allowance estimates should be based on a comprehensive, well-documented, and

consistently applied analysis of the loan portfolio; and

• The loan loss allowance should take into consideration all available information existing as of the financial statement date, including environmental factors such as industry, geographical, economic, and political factors.

Estimated Credit Losses

At the end of each quarter, or more frequently if warranted, the bank analyzes the collectibility of its loans and leases held for investment (“loans”).  This policy doesn’t apply to loans carried at fair value, loans held for sale, or off-balance sheet credit exposures.  It is typically the responsibility of the Chief Financial Officer and the Chief Credit Officer for the preparation of the ALLL analysis and reports.

Estimated credit losses are defined as an estimate of the current amount of loans that is probable the institution will be unable to collect given the facts and circumstances as of the evaluation date.   Estimated credit losses represent net charge-offs that are likely to be realized for a loan or group of loans.  These estimated credit losses will meet the criteria for accrual of a loss contingency through the Provision for loan and lease losses, (PLLL).  When available information confirms that specific loans or portions thereof are uncollectible, these amounts will be promptly charged off against the ALLL.

Estimates of credit losses will 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, these estimates will 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 loans effective interest rate.  2) The loan’s observable market price, or 3) the fair value of the collateral if the loan is collateral dependent.

The bank chooses the appropriate FAS 114 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 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 therefore a confirmed loss will be promptly charged off against the ALLL.  All other loans, including individually evaluated loans determined not to be impaired under FAS 114, will be included in a group of loans that is evaluated for impairment under FAS 5.

Responsibilities of the Board of Directors and Management

The bank’s management is responsible for maintaining the ALLL at an appropriate level and for documenting its analysis according to the standard set forth in this policy.  Thus, management will evaluate the ALLL reported on the balance sheet at the end of each quarter 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.

It is management’s responsibility to:

• Maintain a process for determining that an appropriate level for the ALLL is based on a comprehensive, well-documented, and consistently applied analysis of its loan portfolio. The analysis should consider all significant factors that affect the collectibility of the portfolio and should support the credit losses estimated by this process.

• Have an effective loan review system and controls (including an effective

loan classification or credit grading system) that identify, monitor, and address    asset quality problems in an accurate and timely manner. To be effective, the institution’s loan review system and controls must be responsive to changes in             internal and external factors affecting the level of credit risk in the portfolio.

• Have adequate data capture and reporting systems to supply the information necessary to support and document its estimate of an appropriate ALLL.

• The institution evaluates any loss estimation models before they are employed and modifies the models’ assumptions, as needed, to ensure that the resulting loss estimates are consistent with GAAP.  Management must demonstrate this consistency and document its evaluations and conclusions regarding the appropriateness of estimating credit losses with the models or other estimation tools. Management must also document and support any adjustments made to the models or to the output of the models in determining the estimated credit losses.

• All losses on loans or portions of loans that based upon available information

are determined to be uncollectible will be promptly charged off.

• Management periodically validates the ALLL Methodology. This 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.  Alpha Bank & Trust will use a qualified independent third party review firm to perform this review on at least a semi-annual basis.

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:

• Reviewing and approving the institution’s written ALLL, policies and procedures at least annually.

• Reviewing management’s assessment and justification that the loan review system is sound and appropriate for the size and complexity of the institution.

• Reviewing management’s assessment and justification for the amounts estimated and reported each period for the PLLL and the ALLL.

• Requiring management to periodically validate and, when appropriate, revise the ALLL methodology.

• Review of management’s ALLL reports at least ten (10) days prior to the end of each quarter, in order that the finding of the board of directors with respect to the allowance may be properly reported in the quarterly reports of, “The Statement of Condition” and “The Income Statement”.  A deficiency in the allowance is to be remedied in the calendar quarter it is discovered, prior to preparing the bank’s financial reports.

• The minutes of the board of directors meeting at which the review of the ALLL  indicate the results of the review.

Factors to Consider in the estimation of Credit Losses

The bank determines it’s 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.  If a bank is a new bank, management may utilize the loss experience of comparable size institutions with similar types of credit assets.   Management will also consider those qualitative or environment 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:

• Changes in lending policies and procedures including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses.
• Changes in international, national, regional and local economic and business conditions and developments that affect the collectibility of the portfolio, including the condition of various market segments.
• Changes in the nature an volume of the portfolio and in the terms of loans
• Changes in the experience, ability, and depth of lending management and other relevant staff.
• Changes in the volume and severity of past due loans, the volume of non-accrual loans, and the volume and severity of adversely classified assets.
• Changes in the quality of the institution’s loan review system
• Changes in the value of underlying collateral for collateral-dependent loans.
• The existence and effect of any concentrations of credit, and changes in the level of such concentrations
• The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the institution’s existing portfolio.

FAS 114

When determining the FAS 114 component of the ALLL for individually impaired loans the bank must 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. The bank also bases the 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 will be the best estimate based on reasonable and supportable assumptions and projections.

Loan Grading System

Banks have typically implemented a loan grading system which classifies loans into various risk categories. Shown below are typical loan grading categories and representative loan loss allowance percentages.  This was the previous method of calculating the loan loss allowance which has been replaced with the instructions per the Interagency Guidance; however the loan grading system is typically still utilized.

Loan Grade ALLL %

1. Very Low Risk                     .25%

2. Minimal Risk                        .80%

3. Satisfactory Risk                   1.00%

4. Acceptable Risk                   1.25%

5. Watch Assets                       2.00%

6. OAEM Assets                      5.00%

7. Substandard Assets              15.00%

8. Doubtful Assets                    50.00%

9. Loss                                     100.00%

Very Low Risk

These are the highest quality loans, with unquestioned repayment ability and/or collateral consisting of government obligations; Bank CD’s or cash value of life insurance of “A” rated insurance companies.  Collateral coverage should exceed policy requirements.

Minimal Risk

A minimal risk loan has excellent credit history and payment performance and superior earnings, liquidity and cash flow.  Collateral is of highest quality and/or secured above normal requirements.

Satisfactory Risk

A satisfactory risk loan has earnings and cash flow is consistent and acceptable, with no apparent weaknesses but may be secured by high quality collateral.

Acceptable Risk

An acceptable risk loan is a loan with adequate earnings, liquidity, cash flow and leverage in relation to norms and peer levels, but may be unable to withstand major financial setbacks or market and economic downturn is classified here.  The collateral should provide sufficient protection to the bank

Watch List

These loans require more than normal attention due to any of the following items: deterioration of borrower financial condition, repayment ability and/or collateral, increased leverage, adverse effects from downturn in the economy or local market and adverse legal action.  If conditions persist or worsen, could become problem assets.

Special Mention Assets (OAEM)

These are loans with potential weaknesses, which may, if not checked and corrected, weaken the collateral or inadequately protect the bank’s credit position at some future date.  These loans may require resolution of the specific pending events before associated risk can be properly evaluated.  There are criticized loans.

Substandard Assets

Loans, which are inadequately protected by the present sound net worth and paying capacity of the borrower or the collateral pledged.  The credit risk in this situation relates to the possibility that some loss of principal or interest may occur if deficiencies are not promptly corrected.  Generally at least a 15% reserve is warranted on these loans.  A FAS 114 Calculation is also required on these loans.

Doubtful

Loans that are not presently protected by the current sound worth or paying capacity of the borrower or by means of the collateral pledged to the extent that a substantial amount of the principal may be lost if immediate actions to protect the bank’s position are not taken.  In other words the possibility of loss is high.  In these situations, it should be somewhat clear as to the Bank’s loss exposure.  Typically a reserve of 50% is generally warranted.  A FAS 114 Calculation is required on these loans.

Loss

Loss loans are loans which are considered uncollectible, and continuance as a bankable asset is not warranted.  Such loans should not appear on the books of the bank longer than to receive the necessary approval for charge off.

Every loan that is originated is assigned a grade at the time that the loan is approved by the appropriate loan approval authority.  As loans are reviewed by the loan committee, and the status of loans change, loans may be assigned new grades.

Loan Review System

1. Each month the bank typically generates the “Allowance for Loan Loss Evaluation”.       The Loan Committee reviews the, Past Due Loans Report, Maturing Loans Report, Loan Exception Report, and ALLL reports.  Each loan that is over 30 days past due, or is past maturity, or indicates any other weakness is to be reviewed and discussed.  Once a month the bank will also discuss the risk factors identified on the risk factors             report; which are also listed above in the “Factors to Consider in the estimation of  Credit Losses” section as well as the following factors:
   • The results of the Bank’s internal loan review,
   • Loan and lease loss experience,
   • Trends of delinquent and non-accrual loans,
   • An estimate of potential loss exposure of significant credits,
   • Concentrations of credit,
   • Present and prospective economic conditions

1. Utilizing the reports from (1) above, the Chief Financial Officer and the Chief Credit Officer typically prepare a report of the “Loan Portfolio Risk Factors”, and make the appropriate adjustments to the “Qualitative Adjustments for Individual Portfolio Risk Factors” report.  The new resulting adjustment percentages are then be incorporated into the new “Allowance for Loan Loss Evaluation” reports to calculate the current ALLL.

1. A loan is considered to be impaired when:
   • Based upon current information and events, it is probable (the future event is likely to occur) that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.  All amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement.  Usually a loan that is classified as substandard, doubtful or loss or whose terms are modified in a troubled debt restructuring already will have been identified as impaired.
2. Once a loan has been classified sub-standard or determined to be impaired, a FAS 114 calculation is performed.  If the loan is collateral dependent, then an appraisal will be ordered.  Once received the appraisal will be reviewed for reasonableness and the FAS 114 calculation will be performed.
3. Based upon the FAS 114 calculations, the bank prepares the impaired loans report.
4. The new Allowance for Loan Loss Evaluation and “Impaired Loan” reports is then prepared on a monthly basis and presented for approval of the board of directors.

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