By James Adams
The fables of Aesop have been relayed to countless schoolchildren over the millennia since the Greek storyteller first told them in the sixth century BCE. Whether human, animal or elemental, Aesop’s characters never fail to impart a profound moral lesson. The Boy Who Cried Wolf relates the consequences of lost credibility; The Tortoise and the Hare teaches the importance of managing for the long run instead of the short; The North Wind and the Sun depicts the efficacy of persuasion over force.
Aesop poignantly illustrates another principle in the fable of the ant and the grasshopper. The former insect, who is laying up food for winter on a summer day, is challenged by the latter. “Why bother about winter?” says the grasshopper. “We have plenty of food right now.” The wise ant ignores him and resumes his labors. The winter finds the grasshopper dying of hunger as he observes the ant colony feasting on stores it had previously collected. (A 1934 Walt Disney cartoon presents a happy epilogue in which the ants revive the starving grasshopper, who displays his gratitude for their charity by entertaining them with a fiddle concert.)
Whether we’re considering the original, sober ending or the cheerier Disney version, the moral of the story remains the same: if one expects to survive adverse weather, appropriate provisioning is essential. However, Aesop fails to address a very important question: How did the ant colony know how much food it would need to sustain itself through the winter? Notwithstanding their work ethic and general foresight, if the ants had miscalculated the required amount of food storage, they might have met the same fate as the grasshopper (albeit later in the season).
Like the ant colony enduring the winter snow, a bank’s ability to successfully weather a storm of loan losses depends on making adequate provisions beforehand. Clearly, the ants’ calculation is much more straightforward: knowing the size of the colony, the daily food consumption per ant, and the expected duration of winter would enable the queen to make a fairly precise estimate. For bankers, the provisioning process for loan losses is decidedly more intricate – and infinitely more regulated.
In December 2006, the four national bank regulatory agencies – 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, in conjunction with the National Credit Union Administration, issued an updated interagency 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.”
Originally referred to as “the reserve for bad debts,” the ALLL is a bank’s cumulative estimate of uncollectible amounts on its entire loan portfolio, excepting any loans carried at fair value or held for sale, and off-balance sheet exposures. Effectively, the ALLL serves as a buffer to absorb loan charge-offs as they subsequently materialize.
At the end of each quarter (or more frequently if warranted), each institution evaluates the collectability of its loans. To the extent that the previous ALLL falls short of the current loan loss estimate, additional loss provisioning is made through the income statement. Regulatory guidelines dictate that each loan should be evaluated for impairment either on an individual basis (per FAS 114) or on a group basis (per FAS 5).
To reliably assess the need for individual (FAS 114) loan impairments, banks should employ consistent – and dependable – monitoring and risk rating tools which flag underperforming, delinquent, or otherwise at-risk loans using contemporary data. Flagged loans can then be impaired using one of three methodologies. The process can be tedious, but it is fairly straightforward. Unfortunately, appraising potential impairments on pooled loans under FAS 5 jurisdiction is markedly more complicated.
All loans not evaluated under FAS 114, as well as those loans determined not to be impaired by FAS 114 standards, should be grouped into pools of loans with similar risk characteristics and collectively assessed for impairment under FAS 5 guidelines. These homogeneous pools can be determined by loan purpose, collateral type, borrower type, or other criteria. Loss estimates are then typically derived by using historical charge-off rates as a baseline and making qualitative adjustments to reflect changes in lending policies and procedures, credit concentrations, credit quality, broad economic trends, and other factors.
While granting bank managers considerable discretion in the relative weighting and magnitude of these qualitative adjustments, regulators have been unequivocal about the need for banks to develop, maintain and document “a comprehensive, systematic, and consistently applied process” for determining their loss allowance. Written policies and procedures, annually reviewed by bank boards, are to be implemented for both individual and pooled impairment calculations.
Grading individual loans, appropriately pooling others, and making intelligent qualitative adjustments are time-consuming endeavors. Currently, inefficient data gathering processes force many bank personnel to devote the majority of their ALLL assessment hours to assimilating data, rather than analyzing it. Providing sufficient documentation of the myriad assumptions employed in arriving at the ALLL estimate further complicates the procedure.
Anecdotal evidence from the banking community confirms that the heat is on: Regulators are no longer satisfied by the same processes and methodologies which they deemed sufficient two years ago. Bankers need technological solutions that enable them to readily access contemporary data and document the analysis thereof in determining their allowances.
Regrettably, none of Aesop’s original writings remain, leaving historians unsure whether or not he was the true author of his eponymous fables. But while Aesop’s existence is uncertain, the profundity of the fables attributed to him is unquestionable. After 2,400 years, the truism holds: provision wisely now, or pay later. Whether the consequence is hunger or regulatory reprimand, it’s unpleasant in either case.■
James Adams is a senior analyst at Sageworks, a leading provider of credit risk management, loan loss reserve, and stress testing software to financial institutions.