Interagency Policy Statement on Allowance for Loan and Lease Losses (ALLL) Methodologies and Documentation for Banks and Savings Associations

35629

Federal Register / Vol. 66, No. 130 / Friday, July 6, 2001 / Notices

copying in Room CY–A257, 445 12th

Street, SW., Washington, DC or may be

purchased from the Commission’s copy

contractor, ITS, Inc. (202) 857–3800.

Oppositions to these petitions must be

filed by July 23, 2001. See Section 1.4

(b)(1) of the Commission’s rules (47 CFR

1.4(b)(1)). Replies to an opposition must

be filed within 10 days after the time for

filing oppositions has expired.

Subject: Access Charge Reform (CC

Docket No. 96–262).

Number of Petitions Filed: 7.

Subject: Amendment of Digital TV

Table of Allotments (MM Docket No.

01–17).

Number of Petitions Filed: 1.

Subject: Implementation of the Local

Competition Provisions in the

Telecommunications Act of 1996 (CC

Docket No. 96–98).

Intercarrier Compensation for ISP–

Bound Traffic (CC Docket No. 99–68.

Number of Petitions Filed: 5.

Subject: In the Matter of Amendment

of Parts of the Commission’s Rules to

accommodate Advanced Digital

Communications in the 117.975–137

MHZ Band and to Implement Flight

Information Services in the 136–137

MHZ Band (WT Docket No. 00–77).

Number of Petitions Filed: 1.

Subject: In the Matter of Calling Party

Pays Service Option in the Commercial

Mobile Radio Services (WT Docket No.

97–207).

Number of Petitions Filed: 1.

Federal Communications Commission.

Magalie Roman Salas,

Secretary.

[FR Doc. 01–16862 Filed 7–5–01; 8:45 am]

BILLING CODE 6712–01–M

FEDERAL COMMUNICATIONS

COMMISSION

[Report No. 2492]

Petition for Reconsideration of Action

in Rulemaking Proceeding

June 29, 2001.

Petition for Reconsideration has been

filed in the Commission’s rulemaking

proceeding listed in this Public Notice

and published pursuant to 47 CFR

Section 1.429(e). The full text of this

document is available for viewing and

copying in Room CY–A257, 445 12th

Street, SW., Washington, DC or may be

purchased from the Commission’s copy

contractor, ITS, Inc. (202) 857–3800.

Oppositions to this petition must be

filed by July 23, 2001

been

filed in the Commission’s rulemaking

proceeding listed in this Public Notice

and published pursuant to 47 CFR

Section 1.429(e). The full text of this

document is available for viewing and

copying in Room CY–A257, 445 12th

Street, SW., Washington, DC or may be

purchased from the Commission’s copy

contractor, ITS, Inc. (202) 857–3800.

Oppositions to this petition must be

filed by July 23, 2001. See Section

1.4(b)(1) of the Commission’s rules (47

CFR 1.4(b)(1)). Replies to an opposition

must be filed within 10 days after the

time for filing oppositions has expired.

Subject: Implementation of LPTV

Digital Data Service Pilot Project (FCC

01–137).

Number of Petitions Filed: 1.

Federal Communications Commission.

Magalie Roman Salas,

Secretary.

[FR Doc. 01–16863 Filed 7–5–01; 8:45 am]

BILLING CODE 6712–01–M

FEDERAL ELECTION COMMISSION

Sunshine Act Meeting

DATE & TIME: Tuesday, July 10, 2001 at

10:00 a.m.

PLACE: 999 E Street, N.W., Washington,

D.C.

STATUS: This meeting will be closed to

the public.

ITEMS TO BE DISCUSSED:

Compliance matters pursuant to 2

U.S.C. § 437g.

Audits conducted pursuant to 2 U.S.C.

§ 437g, § 438(b), and Title 26, U.S.C.

Matters concerning participation in civil

actions or proceedings or

arbitration.

Internal personnel rules and procedures

or matters affecting a particular

employee.

DATE & TIME: Thursday, July 12, 2001 at

10:00 a.m.

PLACE: 999 E Street, N.W., Washington,

D.C. (Ninth floor).

STATUS: This meeting will be open to the

public.

ITEMS TO BE DISCUSSED:

Correction and Approval of Minutes.

Advisory Opinion 2001–09: Kerrey for

U.S. Senate by counsel, Robert F.

Bauer and Brian G. Svoboda.

Advisory Opinion 2001–10: The

Honorable Jesse L. Jackson, Sr. and

the Jesse L. Jackson, Jr. for Congress

Committee.

Procedures Followed by Administrative

Law Team.

Administrative Matters.

PERSON TO CONTACT FOR INFORMATION:

Mr. Ron Harris, Press Officer,

Telephone: (202) 694–1220.

Mary W. Dove,

Secretary of the Commission.

[FR Doc

ey for

U.S. Senate by counsel, Robert F.

Bauer and Brian G. Svoboda.

Advisory Opinion 2001–10: The

Honorable Jesse L. Jackson, Sr. and

the Jesse L. Jackson, Jr. for Congress

Committee.

Procedures Followed by Administrative

Law Team.

Administrative Matters.

PERSON TO CONTACT FOR INFORMATION:

Mr. Ron Harris, Press Officer,

Telephone: (202) 694–1220.

Mary W. Dove,

Secretary of the Commission.

[FR Doc. 01–17043 Filed 7–3–01; 11:10 am]

BILLING CODE 6715–01–M

FEDERAL FINANCIAL INSTITUTIONS

EXAMINATION COUNCIL

Policy Statement on Allowance for

Loan and Lease Losses Methodologies

and Documentation for Banks and

Savings Institutions

July 2, 2001.

AGENCY: Federal Financial Institutions

Examination Council.

ACTION: Notice of final interagency

policy statement.

SUMMARY: The Federal Financial

Institutions Examination Council

(FFIEC), on behalf of the Board of

Governors of the Federal Reserve

System (FRB), the Federal Deposit

Insurance Corporation (FDIC), the Office

of the Comptroller of the Currency

(OCC), and the Office of Thrift

Supervision (OTS) (collectively referred

to as the ‘‘banking agencies’’), is

adopting an interagency Policy

Statement on Allowance for Loan and

Lease Losses (ALLL) Methodologies and

Documentation for Banks and Savings

Institutions (Policy Statement). The

National Credit Union Administration

(NCUA), also a member of the FFIEC, is

currently reviewing this policy and may

issue similar guidance specifically

directed toward credit unions. This

Policy Statement is intended to provide

guidance on the design and

implementation of ALLL methodologies

and supporting documentation

practices.

EFFECTIVE DATE: The Policy Statement is

effective immediately.

FOR FURTHER INFORMATION CONTACT:

FRB: Linda V. Griffith, Supervisory

Financial Analyst, (202) 452–3506,

Division of Banking Supervision and

Regulation, Board of Governors of the

Federal Reserve System, 20th Street and

Constitution Avenue, NW., Washington,

DC 20551.

FDIC: Doris L. Marsh, Examination

Specialist, Division of Supervision,

EFFECTIVE DATE: The Policy Statement is

effective immediately.

FOR FURTHER INFORMATION CONTACT:

FRB: Linda V. Griffith, Supervisory

Financial Analyst, (202) 452–3506,

Division of Banking Supervision and

Regulation, Board of Governors of the

Federal Reserve System, 20th Street and

Constitution Avenue, NW., Washington,

DC 20551.

FDIC: Doris L. Marsh, Examination

Specialist, Division of Supervision,

(202) 898–8905, FDIC, 550 17th Street,

NW., Washington, DC 20429.

OCC: Richard Shack, Senior

Accountant, Chief Accountant’s Office,

Core Policy Division, (202) 874–5411, or

Louise A. Francis, National Bank

Examiner, Chief Accountant’s Office,

Core Policy Division, (202) 874–1306,

Office of the Comptroller of the

Currency, 250 E Street, SW.,

Washington, DC 20219.

OTS: William Magrini, Senior Project

Manager, Policy Division, (202) 906–

5744, or Harrison E. Greene, Jr.,

Securities Accountant, Accounting

Policy Division, (202) 906–7933, Office

of Thrift Supervision, 1700 G Street,

NW., Washington, DC 20552.

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Federal Register / Vol. 66, No. 130 / Friday, July 6, 2001 / Notices

1 In addition, the American Institute of Certified

Public Accountants (AICPA) is developing guidance

on the accounting for loan losses and the

techniques for measuring probable incurred losses

in a loan portfolio.

2 Institutions should refer to the guidelines

adopted by their primary federal regulator as

follows: For national banks, Appendix A to Part 30;

for state member banks, Appendix D to Part 208;

for state nonmember banks, Appendix A to Part

364; for savings associations, Appendix A to Part

570.

SUPPLEMENTARY INFORMATION:

I

and the

techniques for measuring probable incurred losses

in a loan portfolio.

2 Institutions should refer to the guidelines

adopted by their primary federal regulator as

follows: For national banks, Appendix A to Part 30;

for state member banks, Appendix D to Part 208;

for state nonmember banks, Appendix A to Part

364; for savings associations, Appendix A to Part

570.

SUPPLEMENTARY INFORMATION:

I. Background

On March 10, 1999, the Federal

Deposit Insurance Corporation, the

Federal Reserve Board, the Office of the

Comptroller of the Currency, the Office

of Thrift Supervision, and the Securities

and Exchange Commission (together,

the Agencies) issued a joint letter to

financial institutions on the allowance

for loan and lease losses (the Joint

Letter). In the Joint Letter, the Agencies

agreed to establish a Joint Working

Group to study ALLL issues and to

assist financial institutions by providing

them with improved guidance on this

topic. The Agencies agreed that the Joint

Working Group would develop and

issue parallel guidance for two key areas

regarding the ALLL:

• Appropriate methodologies and

supporting documentation, and

• Enhanced disclosures.

This Policy Statement represents the

banking agencies’ guidance to banks and

savings institutions relating to

methodologies and supporting

documentation for the ALLL. The

Securities and Exchange Commission

staff has issued parallel guidance on this

topic for public companies in Staff

Accounting Bulletin No. 102.1

This Policy Statement clarifies the

banking agencies’ expectations

regarding methodologies and

documentation support for the ALLL.

For financial reporting purposes,

including regulatory reporting, the

provision for loan and lease losses and

the ALLL must be determined in

accordance with generally accepted

accounting principles (GAAP). GAAP

requires that an institution maintain

written documentation to support the

amounts of the ALLL and the provision

for loan and lease losses reported in the

financial statements

for the ALLL.

For financial reporting purposes,

including regulatory reporting, the

provision for loan and lease losses and

the ALLL must be determined in

accordance with generally accepted

accounting principles (GAAP). GAAP

requires that an institution maintain

written documentation to support the

amounts of the ALLL and the provision

for loan and lease losses reported in the

financial statements.

The Policy Statement does not change

existing accounting guidance in, or

modify the documentation requirements

of, GAAP or guidance provided in the

relevant joint interagency statements

issued by the Agencies. It is intended to

supplement, not replace, the guidance

the banking agencies provided in their

Interagency Policy Statement on the

Allowance for Loan and Lease Losses,

which was issued in December 1993. It

is also intended to supplement guidance

the banking agencies provided in their

interagency guidelines establishing

standards for safety and soundness that

were issued in 1995 and 1996 pursuant

to section 39 of the Federal Deposit

Insurance Act (FDI Act).2 Under the

guidelines for asset quality, each

institution should estimate and

establish a sufficient ALLL supported by

adequate documentation. This Policy

Statement does not address or change

current guidance regarding loan charge-

offs; therefore, institutions should

continue to follow existing regulatory

guidance that addresses the timing of

charge-offs.

The guidance in this Policy Statement

recognizes that institutions should

adopt methodologies and

documentation practices that are

appropriate for their size and

complexity. For institutions with fewer

and less complex loan products, the

amount of supporting documentation

for the ALLL may be less exhaustive

than for institutions with more complex

loan products or portfolios

timing of

charge-offs.

The guidance in this Policy Statement

recognizes that institutions should

adopt methodologies and

documentation practices that are

appropriate for their size and

complexity. For institutions with fewer

and less complex loan products, the

amount of supporting documentation

for the ALLL may be less exhaustive

than for institutions with more complex

loan products or portfolios.

Recognizing that a primary mission of

the banking agencies is to support a safe

and sound banking system, examiners

will continue to evaluate the overall

adequacy of the ALLL, including the

adequacy of supporting documentation,

to ensure that it is appropriate. While

the Policy Statement generally does not

provide guidance to examiners in

conducting safety and soundness

examinations, examiners may criticize

institutions that fail to document and

maintain an adequate ALLL in

accordance with this Policy Statement

and other banking agency guidance. In

such cases, institution management may

be cited for engaging in unsafe and

unsound banking practices and may be

subject to further supervisory action.

II. The Proposed Policy Statement

The FFIEC sought public comment on

a proposed policy statement on ALLL

methodologies and documentation

practices for banks and savings

institutions on September 7, 2000 (65

FR 54268). The proposal indicated that

the purpose of the policy statement was

to provide financial institutions with

enhanced guidance on appropriate

ALLL methodologies and

documentation practices.

The proposed Policy Statement

explained that the board of directors of

each institution is responsible for

ensuring that controls are in place to

determine the appropriate level of the

ALLL. It also emphasized the banking

agencies’ long-standing position that

institutions should maintain and

support the ALLL with documentation

that is consistent with their stated

policies and procedures, GAAP, and

applicable supervisory guidance.

The proposal described significant

aspects of ALLL methodologies and

documentation practices

ols are in place to

determine the appropriate level of the

ALLL. It also emphasized the banking

agencies’ long-standing position that

institutions should maintain and

support the ALLL with documentation

that is consistent with their stated

policies and procedures, GAAP, and

applicable supervisory guidance.

The proposal described significant

aspects of ALLL methodologies and

documentation practices. Specifically,

the proposal provided guidance on

maintaining and documenting policies

and procedures that are appropriately

tailored to the size and complexity of

the institution and its loan portfolio.

The proposal stated that an institution’s

ALLL methodology must be a thorough,

disciplined, and consistently applied

process that incorporates management’s

current judgments about the credit

quality of the loan portfolio.

The proposal also discussed the

methodology and documentation

needed to support ALLL estimates

prepared in accordance with GAAP,

which requires loss estimates based

upon reviews of individual loans and

groups of loans. The proposal stated that

after determining the allowance on

individually reviewed loans and groups

of loans, management should

consolidate those loss estimates and

summarize the amount to be reported in

the financial statements for the ALLL.

To verify that the ALLL methodology is

appropriate and conforms to GAAP and

supervisory guidance, a party who is

independent from the ALLL estimation

process should review the methodology

and its application in a manner

appropriate to the size and complexity

of the institution.

The proposal included illustrations of

implementation practices that

institutions may find useful for

enhancing their own ALLL practices; an

appendix that provided examples of

certain key aspects of ALLL guidance; a

summary of applicable GAAP guidance;

and a bibliographical list of relevant

GAAP guidance, joint interagency

statements, and other literature on ALLL

issues.

III. Discussion of Public Comments

A

al included illustrations of

implementation practices that

institutions may find useful for

enhancing their own ALLL practices; an

appendix that provided examples of

certain key aspects of ALLL guidance; a

summary of applicable GAAP guidance;

and a bibliographical list of relevant

GAAP guidance, joint interagency

statements, and other literature on ALLL

issues.

III. Discussion of Public Comments

A. General Comments

The FFIEC received 31 letters

commenting on the proposed policy

statement. Twenty financial

organizations submitted comments,

whose size (based upon total assets)

ranged from $18 million to $450 billion.

The other letters were primarily

submitted by industry trade groups and

the accounting profession.

Two of the commenters fully

supported the guidance in the proposed

policy statement. Thirteen commenters

opposed issuance of the policy

statement. The commenters who oppose

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Federal Register / Vol. 66, No. 130 / Friday, July 6, 2001 / Notices

the guidance expressed two primary

concerns. First, they believe

institutions, particularly smaller

institutions, will need to unnecessarily

increase resources dedicated to ensure

compliance with the guidance. Second,

they thought that issuance of the policy

statement may be premature given the

ALLL guidance expected to be

developed by the AICPA. The other

commenters generally supported the

guidance with certain modifications.

The two commenters who supported

the proposed policy statement in the

form it was issued believe that they are

already in compliance with the

proposal’s requirements. They

understood that the guidance did not

attempt to expand current GAAP

requirements and allowed institutions

to continue to use judgment in

implementing loan loss estimation

methodologies that are appropriate to

individual institutions

two commenters who supported

the proposed policy statement in the

form it was issued believe that they are

already in compliance with the

proposal’s requirements. They

understood that the guidance did not

attempt to expand current GAAP

requirements and allowed institutions

to continue to use judgment in

implementing loan loss estimation

methodologies that are appropriate to

individual institutions.

The banking agencies believe that

institutions currently complying with

GAAP should not need to dedicate

additional resources to create or support

the ALLL included in their regulatory

reports. The banking agencies have

expected institutions to follow GAAP,

as it applies to the ALLL, for regulatory

reporting purposes for a number of

years. The proposal is consistent with

existing GAAP, which requires that

allowances be well documented, with

clear explanations of the supporting

analysis and rationale. The banking

agencies encourage institutions to

carefully evaluate their current ALLL

methodologies and supporting

documentation practices as well as

other credit risk management practices

and reports before making significant

changes to their current practices or

creating new processes, reports, or other

supporting documents in order to follow

this guidance.

Some commenters suggested the

Policy Statement should include the

banking agencies’ views on the ALLL

guidance being developed by the

AICPA. While the attached Policy

Statement mentions that the AICPA is

developing guidance on the ALLL, a

description of that project’s scope or a

summary of its anticipated guidance is

outside the scope of this Policy

Statement. Furthermore, the AICPA

continues to develop its guidance, and

the Agencies are closely monitoring and

actively contributing to that process.

Several commenting financial

institutions indicated that following the

guidance may prompt a reduction in the

ALLL level at their institutions

tion of that project’s scope or a

summary of its anticipated guidance is

outside the scope of this Policy

Statement. Furthermore, the AICPA

continues to develop its guidance, and

the Agencies are closely monitoring and

actively contributing to that process.

Several commenting financial

institutions indicated that following the

guidance may prompt a reduction in the

ALLL level at their institutions.

However, as noted above, institutions

are already required to follow GAAP

when determining the ALLL and the

guidance does not change existing

GAAP; therefore, following this Policy

Statement should not result in

adjustments to the ALLL by institutions

following GAAP.

Several commenters suggested that

documentation requirements for small

or noncomplex institutions should be

substantially different than the guidance

for larger or more complex institutions.

The guidance in the policy statement

includes a broad description of the steps

taken during the ALLL estimation

process that must be documented. The

types of documentation described in the

examples illustrate that management

has considerable flexibility in

determining the appropriate level and

type of supporting documentation given

the type of loans and associated credit

risks being evaluated. Additionally, the

guidance specifically states that

institutions with less complex products

or portfolios may consider combining

some of the procedures outlined in the

proposed guidance. Furthermore, when

appropriate, these institutions may

utilize documentation that is already

being generated for other purposes to

support their ALLLs. The banking

agencies believe these suggestions will

assist these institutions in supporting

their ALLLs without any unnecessary

burden.

A number of the commenters

suggested that the guidance in the

policy statement should clarify the

banking agencies’ position on the term

‘‘unallocated’’ ALLLs

ions may

utilize documentation that is already

being generated for other purposes to

support their ALLLs. The banking

agencies believe these suggestions will

assist these institutions in supporting

their ALLLs without any unnecessary

burden.

A number of the commenters

suggested that the guidance in the

policy statement should clarify the

banking agencies’ position on the term

‘‘unallocated’’ ALLLs. The guidance

recognizes that, regardless of the

terminology that an institution uses to

label portions of its ALLL, the entire

ALLL should be determined in

accordance with GAAP and supported

with adequate documentation.

B. Changes to the Proposal in Response

to Comments

One issue that was raised by some

commenters was concern that the Policy

Statement would confuse the distinction

between current GAAP requirements

and what would be considered best

practices in corporate governance. They

believe that some of the documentation

requirements contained in the proposed

policy statement are not requirements of

GAAP. In response to these comments,

a footnote was added to the Policy

Statement to clarify how the Policy

Statement describes, but does not

increase, the documentation

requirements already existing within

GAAP. The footnote states that the

documentation guidance in the Policy

Statement is predominantly based upon

certain specifically identified

pronouncements that have been issued

by the Financial Accounting Standards

Board, the Emerging Issues Task Force,

the American Institute of Certified

Public Accountants, and the SEC. Such

pronouncements represent established

accounting principles or are widely

recognized as being generally accepted.

A few commenters were concerned

that the discussion in the proposed

policy statement regarding the

estimation of loan losses for groups of

loans based upon historical loss data

meant that institutions were prohibited

from using loss estimation methods

other than those based upon historical

loss data

s represent established

accounting principles or are widely

recognized as being generally accepted.

A few commenters were concerned

that the discussion in the proposed

policy statement regarding the

estimation of loan losses for groups of

loans based upon historical loss data

meant that institutions were prohibited

from using loss estimation methods

other than those based upon historical

loss data. The application of historical

loss rates to segmented portions of the

loan portfolio, adjusted for

environmental factors, is one way to

estimate ALLLs for pools of loans.

However, other methods are acceptable

if they estimate losses in accordance

with GAAP. The Policy Statement has

been revised to refer to other types of

loss estimation techniques.

A few commenters questioned the

banking agencies’ intent in including

examples of documentation in the Q&A

portion of the proposed policy

statement. They interpreted the

examples to be a list of requirements or

a ‘‘safe harbor’’ of supporting

documentation. The banking agencies

included these examples to assist

institutions in generating ideas on how

to implement the guidance and did not

intend to create a list of required

documents. So that the purpose of the

examples is better understood, the

banking agencies have clarified the

language in the examples and have

added an introductory paragraph to the

Q&A section in Appendix A.

Lastly, some commenters suggested

the guidance in the proposed policy

statement placed undue burden upon

financial institutions’ boards of

directors. The banking agencies did not

intend to expand directors’

responsibilities beyond those that

currently exist. At present, directors are

responsible for approving ALLL policies

and attesting to the validity of the

regulatory reports, which includes the

ALLL. While the board of directors has

ultimate responsibility for these

functions, daily administration of

policies and recordkeeping may be

delegated to operating management

ot

intend to expand directors’

responsibilities beyond those that

currently exist. At present, directors are

responsible for approving ALLL policies

and attesting to the validity of the

regulatory reports, which includes the

ALLL. While the board of directors has

ultimate responsibility for these

functions, daily administration of

policies and recordkeeping may be

delegated to operating management. The

banking agencies have clarified the

guidance to state that the scope of board

of directors’ responsibilities is not

changed or expanded with the issuance

of this Policy Statement.

IV. Paperwork Reduction Act

In accordance with the Paperwork

Reduction Act of 1995 (44 U.S.C.

chapter 35), the banking agencies have

reviewed the Policy Statement and

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1 A bibliography is attached that lists applicable

ALLL GAAP guidance, interagency statements, and

other reference materials that may assist in

understanding and implementing an ALLL in

accordance with GAAP. See Appendix B for

additional information on applying GAAP to

determine the ALLL.

2 All institutions are encouraged to establish audit

committees; however, at small institutions without

audit committees, the board of directors retains this

responsibility.

3 Institutions and their auditors should refer to

Statement on Auditing Standards No. 61,

Communication With Audit Committees (as

amended by Statement on Auditing Standards No.

90, Audit Committee Communications), which

requires certain discussions between the auditor

and the audit committee. These discussions should

include items, such as accounting policies and

estimates, judgments, and uncertainties that have a

significant impact on the accounting information

included in the financial statements

With Audit Committees (as

amended by Statement on Auditing Standards No.

90, Audit Committee Communications), which

requires certain discussions between the auditor

and the audit committee. These discussions should

include items, such as accounting policies and

estimates, judgments, and uncertainties that have a

significant impact on the accounting information

included in the financial statements.

4 The banking agencies are the Federal Deposit

Insurance Corporation, the Federal Reserve Board,

the Office of the Comptroller of the Currency, and

the Office of Thrift Supervision.

5 Institutions should refer to the guidelines

adopted by their primary federal regulator as

follows: For national banks, Appendix A to Part 30;

for state member banks, Appendix D to Part 208;

for state nonmember banks, Appendix A to Part

364; for savings associations, Appendix A to Part

570.

6 The documentation guidance within this Policy

Statement is predominantly based upon the GAAP

guidance from Financial Accounting Standards

Board (FASB) Statement Numbers 5 and 114 (FAS

5 and FAS 114, respectively); Emerging Issues Task

Force Topic No. D–80 (EITF Topic D–80 and

attachments), Application of FASB Statements No.

5 and No. 114 to a Loan Portfolio (which includes

the Viewpoints Article—an article issued in 1999

by FASB staff providing guidance on certain issues

regarding the ALLL, particularly on the application

of FAS 5 and FAS 114 and how these statements

interrelate), Chapter 7—Credit Losses, the American

Institute of Certified Public Accountants’ (AICPA)

Audit and Accounting Guide, Banks and Savings

Institutions—2000 edition (AICPA Audit Guide);

and the Securities and Exchange Commission’s

(SEC) Financial Reporting Release No. 28 (FRR 28).

7 Failure to maintain adequate supporting

documentation does not relieve an institution of its

obligation to record an appropriate ALLL

dit Losses, the American

Institute of Certified Public Accountants’ (AICPA)

Audit and Accounting Guide, Banks and Savings

Institutions—2000 edition (AICPA Audit Guide);

and the Securities and Exchange Commission’s

(SEC) Financial Reporting Release No. 28 (FRR 28).

7 Failure to maintain adequate supporting

documentation does not relieve an institution of its

obligation to record an appropriate ALLL.

8 This position is fully described in the SEC’s FRR

28, in which the SEC indicates that the books and

records of public companies engaged in lending

activities should include documentation of the

rationale supporting each period’s determination

that the ALLL and provision amounts reported were

adequate.

determined that it does not add any

collections of information pursuant to

the Act.

V. Policy Statement

The text of the Policy Statement

follows:

Policy Statement on Allowance for

Loan and Lease Losses Methodologies

and Documentation for Banks and

Savings Institutions

July 2, 2001.

Boards of directors of banks and

savings institutions are responsible for

ensuring that their institutions have

controls in place to consistently

determine the allowance for loan and

lease losses (ALLL) in accordance with

the institutions’ stated policies and

procedures, generally accepted

accounting principles (GAAP), and

ALLL supervisory guidance.1 To fulfill

this responsibility, boards of directors

instruct management to develop and

maintain an appropriate, systematic,

and consistently applied process to

determine the amounts of the ALLL and

provisions for loan losses. Management

should create and implement suitable

policies and procedures to communicate

the ALLL process internally to all

applicable personnel. Regardless of who

develops and implements these policies,

procedures, and underlying controls,

the board of directors should assure

themselves that the policies specifically

address the institution’s unique goals,

systems, risk profile, personnel, and

other resources before approving them

ement suitable

policies and procedures to communicate

the ALLL process internally to all

applicable personnel. Regardless of who

develops and implements these policies,

procedures, and underlying controls,

the board of directors should assure

themselves that the policies specifically

address the institution’s unique goals,

systems, risk profile, personnel, and

other resources before approving them.

Additionally, by creating an

environment that encourages personnel

to follow these policies and procedures,

management improves procedural

discipline and compliance.

The determination of the amounts of

the ALLL and provisions for loan and

lease losses 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 reporting

date. The amounts reported each period

for the provision for loan and lease

losses and the ALLL should be reviewed

and approved by the board of directors.

To ensure the methodology remains

appropriate for the institution, the board

of directors should have the

methodology periodically validated and,

if appropriate, revised. Further, the

audit committee2 should oversee and

monitor the internal controls over the

ALLL determination process.3

The banking agencies’4 have long-

standing examination policies that call

for examiners to review an institution’s

lending and loan review functions and

recommend improvements, if needed.

Additionally, in 1995 and 1996, the

banking agencies adopted interagency

guidelines establishing standards for

safety and soundness, pursuant to

Section 39 of the Federal Deposit

Insurance Act (FDI Act).5 The

interagency asset quality guidelines and

the guidance in this paper assist an

institution in estimating and

establishing a sufficient ALLL

supported by adequate documentation,

as required under the FDI Act

in 1995 and 1996, the

banking agencies adopted interagency

guidelines establishing standards for

safety and soundness, pursuant to

Section 39 of the Federal Deposit

Insurance Act (FDI Act).5 The

interagency asset quality guidelines and

the guidance in this paper assist an

institution in estimating and

establishing a sufficient ALLL

supported by adequate documentation,

as required under the FDI Act.

Additionally, the guidelines require

operational and managerial standards

that are appropriate for an institution’s

size and the nature and scope of its

activities.

For financial reporting purposes,

including regulatory reporting, the

provision for loan and lease losses and

the ALLL must be determined in

accordance with GAAP. GAAP requires

that allowances be well documented,

with clear explanations of the

supporting analyses and rationale.6 This

Policy Statement describes but does not

increase the documentation

requirements already existing within

GAAP. Failure to maintain, analyze, or

support an adequate ALLL in

accordance with GAAP and supervisory

guidance is generally an unsafe and

unsound banking practice.7

This guidance applies equally to all

institutions, regardless of the size.

However, 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. Thus, much

of the supporting documentation

required for an institution with more

complex products or portfolios may be

combined into fewer supporting

documents in an institution with less

complex products or portfolios. For

example, simplified documentation can

include spreadsheets, check lists, and

other summary documents that many

institutions currently use. Illustrations

A and C provide specific examples of

how less complex institutions may

determine and document portions of

their loan loss allowance

ios may be

combined into fewer supporting

documents in an institution with less

complex products or portfolios. For

example, simplified documentation can

include spreadsheets, check lists, and

other summary documents that many

institutions currently use. Illustrations

A and C provide specific examples of

how less complex institutions may

determine and document portions of

their loan loss allowance.

Documentation Standards

Appropriate written supporting

documentation for the loan loss

provision and allowance facilitates

review of the ALLL process and

reported amounts, builds discipline and

consistency into the ALLL

determination process, and improves

the process for estimating loan and lease

losses by helping to ensure that all

relevant factors are appropriately

considered in the ALLL analysis. An

institution should document the

relationship between the findings of its

detailed review of the loan portfolio and

the amount of the ALLL and the

provision for loan and lease losses

reported in each period.8

At a minimum, institutions should

maintain written supporting

documentation for the following

decisions, strategies, and processes:

(1) Policies and procedures:

(a) Over the systems and controls that

maintain an appropriate ALLL and

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9 Further explanation is presented in the

Methodology section that appears below.

10 In addition to the supporting documentation

requirements for financial institutions, as described

in interagency asset quality guidelines, public

companies are required to comply with the books

and records provisions of the Securities Exchange

Act of 1934 (Exchange Act). Under Sections

13(b)(2)-(7) of the Exchange Act, registrants must

make and keep books, records, and accounts,

which, in reasonable detail, accurately and fairly

reflect the transactions and dispositions of assets of

the registrant

nteragency asset quality guidelines, public

companies are required to comply with the books

and records provisions of the Securities Exchange

Act of 1934 (Exchange Act). Under Sections

13(b)(2)-(7) of the Exchange Act, registrants must

make and keep books, records, and accounts,

which, in reasonable detail, accurately and fairly

reflect the transactions and dispositions of assets of

the registrant. Registrants also must maintain

internal accounting controls that are sufficient to

provide reasonable assurances that, among other

things, transactions are recorded as necessary to

permit the preparation of financial statements in

conformity with GAAP. See also SEC Staff

Accounting Bulletin No. 99, Materiality.

11 Also, refer to paragraph 7.05 of the AICPA

Audit Guide.

(b) Over the ALLL methodology,

(2) Loan grading system or process,

(3) Summary or consolidation of the

ALLL balance,

(4) Validation of the ALLL

methodology, and

(5) Periodic adjustments to the ALLL

process.

The following sections of this Policy

Statement provide guidance on

significant aspects of ALLL

methodologies and documentation

practices. Specifically, the paper

provides documentation guidance on:

(1) Policies and Procedures,

(2) Methodology,

(3) ALLL Under FASB Statement of

Financial Accounting Standards No.

114, Accounting by Creditors for

Impairment of a Loan (FAS 114),

(4) ALLL Under FASB Statement of

Financial Accounting Standards No. 5,

Accounting for Contingencies (FAS 5),

(5) Consolidating the Loss Estimates,

and

(6) Validating the ALLL Methodology.

Policies and Procedures

Financial institutions utilize a wide

range of policies, procedures, and

control systems in their ALLL process.

Sound policies should be appropriately

tailored to the size and complexity of

the institution and its loan portfolio.

In order for an institution’s ALLL

methodology to be effective, the

institution’s written policies and

procedures for the systems and controls

that maintain an appropriate ALLL

should address but not be limited to:

of policies, procedures, and

control systems in their ALLL process.

Sound policies should be appropriately

tailored to the size and complexity of

the institution and its loan portfolio.

In order for an institution’s ALLL

methodology to be effective, the

institution’s written policies and

procedures for the systems and controls

that maintain an appropriate ALLL

should address but not be limited to:

(1) The roles and responsibilities of

the institution’s departments and

personnel (including the lending

function, credit review, financial

reporting, internal audit, senior

management, audit committee, board of

directors, and others, as applicable) who

determine, or review, as applicable, the

ALLL to be reported in the financial

statements;

(2) The institution’s accounting

policies for loans and loan losses,

including the policies for charge-offs

and recoveries and for estimating the

fair value of collateral, where

applicable;

(3) The description of the institution’s

systematic methodology, which should

be consistent with the institution’s

accounting policies for determining its

ALLL;9 and

(4) The system of internal controls

used to ensure that the ALLL process is

maintained in accordance with GAAP

and supervisory guidance.

An internal control system for the

ALLL estimation process should:

(1) Include measures to provide

assurance regarding the reliability and

integrity of information and compliance

with laws, regulations, and internal

policies and procedures;

(2) Reasonably assure that the

institution’s financial statements

(including regulatory reports) are

prepared in accordance with GAAP and

ALLL supervisory guidance;10 and

(3) Include a well-defined loan review

process containing:

(a) An effective loan grading system

that is consistently applied, identifies

differing risk characteristics and loan

quality problems accurately and in a

timely manner, and prompts

appropriate administrative actions;

nancial statements

(including regulatory reports) are

prepared in accordance with GAAP and

ALLL supervisory guidance;10 and

(3) Include a well-defined loan review

process containing:

(a) An effective loan grading system

that is consistently applied, identifies

differing risk characteristics and loan

quality problems accurately and in a

timely manner, and prompts

appropriate administrative actions;

(b) Sufficient internal controls to

ensure that all relevant loan review

information is appropriately considered

in estimating losses. This includes

maintaining appropriate reports, details

of reviews performed, and identification

of personnel involved; and

(c) Clear formal communication and

coordination between an institution’s

credit administration function, financial

reporting group, management, board of

directors, and others who are involved

in the ALLL determination or review

process, as applicable (e.g., written

policies and procedures, management

reports, audit programs, and committee

minutes).

Methodology

An ALLL methodology is a system

that an institution designs and

implements to reasonably estimate loan

and lease losses as of the financial

statement date. It is critical that ALLL

methodologies incorporate

management’s current judgments about

the credit quality of the loan portfolio

through a disciplined and consistently

applied process.

An institution’s ALLL methodology is

influenced by institution-specific

factors, such as an institution’s size,

organizational structure, business

environment and strategy, management

style, loan portfolio characteristics, loan

administration procedures, and

management information systems.

However, there are certain common

elements an institution should

incorporate in its ALLL methodology

process.

An institution’s ALLL methodology is

influenced by institution-specific

factors, such as an institution’s size,

organizational structure, business

environment and strategy, management

style, loan portfolio characteristics, loan

administration procedures, and

management information systems.

However, there are certain common

elements an institution should

incorporate in its ALLL methodology. A

summary of common elements is

provided in Appendix B.11

Documentation of ALLL Methodology in

Written Policies and Procedures

An institution’s written policies and

procedures should describe the primary

elements of the institution’s ALLL

methodology, including portfolio

segmentation and impairment

measurement. In order for an

institution’s ALLL methodology to be

effective, the institution’s written

policies and procedures should describe

the methodology:

(1) For segmenting the portfolio:

(a) How the segmentation process is

performed (i.e., by loan type, industry,

risk rates, etc.),

(b) When a loan grading system is

used to segment the portfolio:

(i) The definitions of each loan grade,

(ii) A reconciliation of the internal

loan grades to supervisory loan grades,

and

(iii) The delineation of

responsibilities for the loan grading

system.

(2) For determining and measuring

impairment under FAS 114:

(a) The methods used to identify loans

to be analyzed individually;

(b) For individually reviewed loans

that are impaired, how the amount of

any impairment is determined and

measured, including:

(i) Procedures describing the

impairment measurement techniques

available and

(ii) Steps performed to determine

which technique is most appropriate in

a given situation.

(c) The methods used to determine

whether and how loans individually

evaluated under FAS 114, but not

considered to be individually impaired,

should be grouped with other loans that

share common characteristics for

impairment evaluation under FAS 5.

(3) For determining and measuring

impairment under FAS 5:

(ii) Steps performed to determine

which technique is most appropriate in

a given situation.

(c) The methods used to determine

whether and how loans individually

evaluated under FAS 114, but not

considered to be individually impaired,

should be grouped with other loans that

share common characteristics for

impairment evaluation under FAS 5.

(3) For determining and measuring

impairment under FAS 5:

(a) How loans with similar

characteristics are grouped to be

evaluated for loan collectibility (such as

loan type, past-due status, and risk);

(b) How loss rates are determined

(e.g., historical loss rates adjusted for

environmental factors or migration

analysis) and what factors are

considered when establishing

appropriate time frames over which to

evaluate loss experience; and

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12 The referenced ‘‘gray box’’ illustrations are

presented to assist institutions in evaluating how to

implement the guidance provided in this document.

The methods described in the illustrations may not

be suitable for all institutions and are not

considered required processes or actions. For

additional descriptions of key aspects of ALLL

guidance, a series of ALLL Questions and Answers

(Q&As) are included in Appendix A of this paper.

13 An example of a loan segment that does not

generally require an ALLL is loans that are fully

in this document.

The methods described in the illustrations may not

be suitable for all institutions and are not

considered required processes or actions. For

additional descriptions of key aspects of ALLL

guidance, a series of ALLL Questions and Answers

(Q&As) are included in Appendix A of this paper.

13 An example of a loan segment that does not

generally require an ALLL is loans that are fully

(c) Descriptions of qualitative factors

(e.g., industry, geographical, economic,

and political factors) that may affect loss

rates or other loss measurements.

The supporting documents for the

ALLL may be integrated in an

institution’s credit files, loan review

reports or worksheets, board of

directors’ and committee meeting

minutes, computer reports, or other

appropriate documents and files.

ALLL Under FAS 114

An institution’s ALLL methodology

related to FAS 114 loans begins with the

use of its normal loan review

procedures to identify whether a loan is

impaired as defined by the accounting

standard. Institutions should document:

(1) The method and process for

identifying loans to be evaluated under

FAS 114 and

(2) The analysis that resulted in an

impairment decision for each loan and

the determination of the impairment

measurement method to be used (i.e.,

present value of expected future cash

flows, fair value of collateral less costs

to sell, or the loan’s observable market

price).

Once an institution has determined

which of the three available

measurement methods to use for an

impaired loan under FAS 114, it should

maintain supporting documentation as

follows:

(1) When using the present value of

expected future cash flows method:

(a) The amount and timing of cash

flows,

(b) The effective interest rate used to

discount the cash flows, and

(c) The basis for the determination of

cash flows, including consideration of

current environmental factors and other

information reflecting past events and

current conditions.

(2) When using the fair value of

collateral method:

using the present value of

expected future cash flows method:

(a) The amount and timing of cash

flows,

(b) The effective interest rate used to

discount the cash flows, and

(c) The basis for the determination of

cash flows, including consideration of

current environmental factors and other

information reflecting past events and

current conditions.

(2) When using the fair value of

collateral method:

(a) How fair value was determined,

including the use of appraisals,

valuation assumptions, and

calculations,

(b) The supporting rationale for

adjustments to appraised values, if any,

(c) The determination of costs to sell,

if applicable, and

(d) Appraisal quality, and the

expertise and independence of the

appraiser.

(3) When using the observable market

price of a loan method:

(a) The amount, source, and date of

the observable market price.

Illustration A describes a practice

used by a small financial institution to

document its FAS 114 measurement of

impairment using a comprehensive

worksheet.12 Q&A #1 and #2 in

Appendix A provide examples of

applying and documenting impairment

measurement methods under FAS 114.

Begin Text Box—Illustration A

(Documenting an ALLL Under FAS 114,

Comprehensive worksheet for the

impairment measurement process): A small

institution utilizes a comprehensive

worksheet for each loan being reviewed

individually under FAS 114. Each worksheet

includes a description of why the loan was

selected for individual review, the

impairment measurement technique used,

the measurement calculation, a comparison

to the current loan balance, and the amount

of the ALLL for that loan. The rationale for

the impairment measurement technique used

(e.g., present value of expected future cash

flows, observable market price of the loan,

fair value of the collateral) is also described

on the worksheet. End Text Box

Some loans that are evaluated

individually for impairment under FAS

114 may be fully collateralized and

therefore require no ALLL

and the amount

of the ALLL for that loan. The rationale for

the impairment measurement technique used

(e.g., present value of expected future cash

flows, observable market price of the loan,

fair value of the collateral) is also described

on the worksheet. End Text Box

Some loans that are evaluated

individually for impairment under FAS

114 may be fully collateralized and

therefore require no ALLL. Q&A #3 in

Appendix A presents an example of an

institution whose loan portfolio

includes fully collateralized loans and

describes the documentation

maintained by that institution to

support its conclusion that no ALLL

was needed for those loans.

ALLL Under FAS 5

Segmenting the Portfolio

For loans evaluated on a group basis

under FAS 5, management should

segment the loan portfolio by

identifying risk characteristics that are

common to groups of loans. Institutions

typically decide how to segment their

loan portfolios based on many factors,

which vary with their business

strategies as well as their information

system capabilities. Smaller institutions

that are involved in less complex

activities often segment the portfolio

into broad loan categories. This method

of segmenting the portfolio is likely to

be appropriate in only small institutions

offering a narrow range of loan

products. Larger institutions typically

offer a more diverse and complex mix

of loan products. Such institutions may

start by segmenting the portfolio into

major loan types but typically have

more detailed information available that

allows them to further segregate the

portfolio into product line segments

based on the risk characteristics of each

portfolio segment. Regardless of the

segmentation method used, an

institution should maintain

documentation to support its conclusion

that the loans in each segment have

similar attributes or characteristics

major loan types but typically have

more detailed information available that

allows them to further segregate the

portfolio into product line segments

based on the risk characteristics of each

portfolio segment. Regardless of the

segmentation method used, an

institution should maintain

documentation to support its conclusion

that the loans in each segment have

similar attributes or characteristics.

As economic and other business

conditions change, institutions often

modify their business strategies, which

may result in adjustments to the way in

which they segment their loan portfolio

for purposes of estimating loan losses.

Illustration B presents an example in

which an institution refined its

segmentation method to more

effectively consider risk factors and

maintains documentation to support

this change.

Begin Text Box—Illustration B

(Documenting Segmenting Practices,

Documenting a refinement in a segmentation

method): An institution with a significant

portfolio of consumer loans performed a

review of its ALLL methodology. The

institution had determined its ALLL based

upon historical loss rates in the overall

consumer portfolio. The ALLL methodology

was validated by comparing actual loss rates

(charge-offs) for the past two years to the

estimated loss rates. During this process, the

institution decided to evaluate loss rates on

an individual product basis (e.g., auto loans,

unsecured loans, or home equity loans). This

analysis disclosed significant differences in

the loss rates on different products. With this

additional information, the methodology was

amended in the current period to segment the

portfolio by product, resulting in a better

estimation of the loan losses associated with

the portfolio. To support this change in

segmentation practice, the credit review

committee records contain the analysis that

was used as a basis for the change and the

written report describing the need for the

change End Text Box.

Institutions use a variety of

documents to support the segmentation

of their portfolios

by product, resulting in a better

estimation of the loan losses associated with

the portfolio. To support this change in

segmentation practice, the credit review

committee records contain the analysis that

was used as a basis for the change and the

written report describing the need for the

change End Text Box.

Institutions use a variety of

documents to support the segmentation

of their portfolios. Some of these

documents include:

(1) Loan trial balances by categories

and types of loans,

(2) Management reports about the mix

of loans in the portfolio,

(3) Delinquency and nonaccrual

reports, and

(4) A summary presentation of the

results of an internal or external loan

grading review.

Reports generated to assess the

profitability of a loan product line may

be useful in identifying areas in which

to further segment the portfolio.

Estimating Loss on Groups of Loans

Based on the segmentation of the loan

portfolio, an institution should estimate

the FAS 5 portion of its ALLL. For those

segments that require an ALLL,13 the

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secured by deposits maintained at the lending

institution.

14 Refer to paragraph 8(b) of FAS 5. Also, the

AICPA is currently developing a Statement of

Position that will provide more specific guidance

on accounting for loan losses.

15 Refer to paragraph 23 of FAS 5.

16 Refer to paragraph 7.13 in the AICPA Audit

Guide.

17 Subsequent to adjustments, there should be no

material differences between the consolidated loss

estimate, as determined by the methodology, and

the final ALLL balance reported in the financial

statements.

institution should estimate the loan and

lease losses, on at least a quarterly basis,

based upon its ongoing loan review

process and analysis of loan

performance

.13 in the AICPA Audit

Guide.

17 Subsequent to adjustments, there should be no

material differences between the consolidated loss

estimate, as determined by the methodology, and

the final ALLL balance reported in the financial

statements.

institution should estimate the loan and

lease losses, on at least a quarterly basis,

based upon its ongoing loan review

process and analysis of loan

performance. The institution should

follow a systematic and consistently

applied approach to select the most

appropriate loss measurement methods

and support its conclusions and

rationale with written documentation.

Regardless of the methods used to

measure losses, an institution should

demonstrate and document that the loss

measurement methods used to estimate

the ALLL for each segment are

determined in accordance with GAAP

as of the financial statement date.14

One method of estimating loan losses

for groups of loans is through the

application of loss rates to the groups’

aggregate loan balances. Such loss rates

typically reflect the institution’s

historical loan loss experience for each

group of loans, adjusted for relevant

environmental factors (e.g., industry,

geographical, economic, and political

factors) over a defined period of time. If

an institution does not have loss

experience of its own, it may be

appropriate to reference the loss

experience of other institutions,

provided that the institution

demonstrates that the attributes of the

loans in its portfolio segment are similar

to those of the loans included in the

portfolio of the institution providing the

loss experience.15 Institutions should

maintain supporting documentation for

the technique used to develop their loss

rates, including the period of time over

which the losses were incurred. If a

range of loss is determined, institutions

should maintain documentation to

support the identified range and the

rationale used for determining which

estimate is the best estimate within the

range of loan losses

xperience.15 Institutions should

maintain supporting documentation for

the technique used to develop their loss

rates, including the period of time over

which the losses were incurred. If a

range of loss is determined, institutions

should maintain documentation to

support the identified range and the

rationale used for determining which

estimate is the best estimate within the

range of loan losses. An example of how

a small institution performs a

comprehensive historical loss analysis

is provided as the first item in

Illustration C.

Before employing a loss estimation

model, an institution should evaluate

and modify, as needed, the model’s

assumptions to ensure that the resulting

loss estimate is consistent with GAAP.

In order to demonstrate consistency

with GAAP, institutions that use loss

estimation models typically document

the evaluation, the conclusions

regarding the appropriateness of

estimating loan losses with a model or

other loss estimation tool, and the

support for adjustments to the model or

its results.

Begin Text Box—Illustration C

(Documenting the Setting of Loss Rates, First

Illustration, Comprehensive loss analysis in a

small institution): A small institution

determines its loss rates based on loss rates

over a three-year historical period. The

analysis is conducted by type of loan and is

further segmented by originating branch

office. The analysis considers charge-offs and

recoveries in determining the loss rate. The

institution also considers the loss rates for

each loan grade and compares them to

historical losses on similarly rated loans in

arriving at the historical loss factor. The

institution maintains supporting

documentation for its loss factor analysis,

including historical losses by type of loan,

originating branch office, and loan grade for

the three-year period.

(Second Illustration, Adjustment of loss

rates for changes in local economic

conditions): An institution develops a factor

to adjust loss rates for its assessment of the

impact of changes in the local economy

institution maintains supporting

documentation for its loss factor analysis,

including historical losses by type of loan,

originating branch office, and loan grade for

the three-year period.

(Second Illustration, Adjustment of loss

rates for changes in local economic

conditions): An institution develops a factor

to adjust loss rates for its assessment of the

impact of changes in the local economy. For

example, when analyzing the loss rate on

commercial real estate loans, the assessment

identifies changes in recent commercial

building occupancy rates. The institution

generally finds the occupancy statistics to be

a good indicator of probable losses on these

types of loans. The institution maintains

documentation that summarizes the

relationship between current occupancy rates

and its loss experience. End Text Box

In developing loss measurements,

institutions should consider the impact

of current environmental factors and

then document which factors were used

in the analysis and how those factors

affected the loss measurements. Factors

that should be considered in developing

loss measurements include the

following:16

(1) Levels of and trends in

delinquencies and impaired loans;

(2) Levels of and trends in charge-offs

and recoveries;

(3) Trends in volume and terms of

loans;

(4) Effects of any changes in risk

selection and underwriting standards,

and other changes in lending policies,

procedures, and practices;

(5) Experience, ability, and depth of

lending management and other relevant

staff;

(6) National and local economic

trends and conditions;

(7) Industry conditions; and

) Levels of and trends in charge-offs

and recoveries;

(3) Trends in volume and terms of

loans;

(4) Effects of any changes in risk

selection and underwriting standards,

and other changes in lending policies,

procedures, and practices;

(5) Experience, ability, and depth of

lending management and other relevant

staff;

(6) National and local economic

trends and conditions;

(7) Industry conditions; and

(8) Effects of changes in credit

concentrations.

For any adjustment of loss

measurements for environmental

factors, the institution should maintain

sufficient, objective evidence to support

the amount of the adjustment and to

explain why the adjustment is necessary

to reflect current information, events,

circumstances, and conditions in the

loss measurements.

The second item in Illustration C

provides an example of how an

institution adjusts its commercial real

estate historical loss rates for changes in

local economic conditions. Q&A #4 in

Appendix A provides an example of

maintaining supporting documentation

for adjustments to portfolio segment loss

rates for an environmental factor related

to an economic downturn in the

borrower’s primary industry. Q&A #5 in

Appendix A describes one institution’s

process for determining and

documenting an ALLL for loans that are

not individually impaired but have

characteristics indicating there are loan

losses on a group basis.

Consolidating the Loss Estimates

To verify that ALLL balances are

presented fairly in accordance with

GAAP and are auditable, management

should prepare a document that

summarizes the amount to be reported

in the financial statements for the ALLL.

The board of directors should review

and approve this summary.

Common elements in such summaries

include:

(1) The estimate of the probable loss

or range of loss incurred for each

category evaluated (e.g., individually

evaluated impaired loans, homogeneous

pools, and other groups of loans that are

collectively evaluated for impairment);

(2) The aggregate probable loss

estimated using the institution’s

methodology;

ectors should review

and approve this summary.

Common elements in such summaries

include:

(1) The estimate of the probable loss

or range of loss incurred for each

category evaluated (e.g., individually

evaluated impaired loans, homogeneous

pools, and other groups of loans that are

collectively evaluated for impairment);

(2) The aggregate probable loss

estimated using the institution’s

methodology;

(3) A summary of the current ALLL

balance;

(4) The amount, if any, by which the

ALLL is to be adjusted;17 and

(5) Depending on the level of detail

that supports the ALLL analysis,

detailed subschedules of loss estimates

that reconcile to the summary schedule.

Illustration D describes how an

institution documents its estimated

ALLL by adding comprehensive

explanations to its summary schedule.

Begin Text Box—Illustration D

(Summarizing Loss Estimates, Descriptive

comments added to the consolidated ALLL

summary schedule): To simplify the

supporting documentation process and to

eliminate redundancy, an institution adds

detailed supporting information to its

summary schedule. For example, this

institution’s board of directors receives,

within the body of the ALLL summary

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1 Question #16 in Exhibit D–80A of EITF Topic

D–80 and attachments indicates that environmental

factors include existing industry, geographical,

economic, and political factors.

schedule, a brief description of the

institution’s policy for selecting loans for

evaluation under FAS 114. Additionally, the

institution identifies which FAS 114

impairment measurement method was used

for each individually reviewed impaired

loan

t D–80A of EITF Topic

D–80 and attachments indicates that environmental

factors include existing industry, geographical,

economic, and political factors.

schedule, a brief description of the

institution’s policy for selecting loans for

evaluation under FAS 114. Additionally, the

institution identifies which FAS 114

impairment measurement method was used

for each individually reviewed impaired

loan. Other items on the schedule include a

brief description of the loss factors for each

segment of the loan portfolio, the basis for

adjustments to loss rates, and explanations of

changes in ALLL amounts from period to

period, including cross-references to more

detailed supporting documents. End Text

Box

Generally, an institution’s review and

approval process for the ALLL relies

upon the data provided in these

consolidated summaries. There may be

instances in which individuals or

committees that review the ALLL

methodology and resulting allowance

balance identify adjustments that need

to be made to the loss estimates to

provide a better estimate of loan losses.

These changes may be due to

information not known at the time of

the initial loss estimate (e.g.,

information that surfaces after

determining and adjusting, as necessary,

historical loss rates, or a recent decline

in the marketability of property after

conducting a FAS 114 valuation based

upon the fair value of collateral). It is

important that these adjustments are

consistent with GAAP and are reviewed

and approved by appropriate personnel.

Additionally, the summary should

provide each subsequent reviewer with

an understanding of the support behind

these adjustments. Therefore,

management should document the

nature of any adjustments and the

underlying rationale for making the

changes. This documentation should be

provided to those making the final

determination of the ALLL amount.

Q&A #6 in Appendix A addresses the

documentation of the final amount of

the ALLL

ould

provide each subsequent reviewer with

an understanding of the support behind

these adjustments. Therefore,

management should document the

nature of any adjustments and the

underlying rationale for making the

changes. This documentation should be

provided to those making the final

determination of the ALLL amount.

Q&A #6 in Appendix A addresses the

documentation of the final amount of

the ALLL.

Validating the ALLL Methodology

An institution’s ALLL methodology is

considered valid when it accurately

estimates the amount of loss contained

in the portfolio. Thus, the institution’s

methodology should include procedures

that adjust loss estimation methods to

reduce differences between estimated

losses and actual subsequent charge-

offs, as necessary.

To verify that the ALLL methodology

is valid and conforms to GAAP and

supervisory guidance, an institution’s

directors should establish internal

control policies, appropriate for the size

of the institution and the type and

complexity of its loan products. These

policies should include procedures for a

review, by a party who is independent

of the ALLL estimation process, of the

ALLL methodology and its application

in order to confirm its effectiveness.

In practice, financial institutions

employ numerous procedures when

validating the reasonableness of their

ALLL methodology and determining

whether there may be deficiencies in

their overall methodology or loan

grading process. Examples are:

(1) A review of trends in loan volume,

delinquencies, restructurings, and

concentrations.

(2) A review of previous charge-off

and recovery history, including an

evaluation of the timeliness of the

entries to record both the charge-offs

and the recoveries.

(3) A review by a party that is

independent of the ALLL estimation

process. This often involves the

independent party reviewing, on a test

basis, source documents and underlying

assumptions to determine that the

established methodology develops

reasonable loss estimates.

nd recovery history, including an

evaluation of the timeliness of the

entries to record both the charge-offs

and the recoveries.

(3) A review by a party that is

independent of the ALLL estimation

process. This often involves the

independent party reviewing, on a test

basis, source documents and underlying

assumptions to determine that the

established methodology develops

reasonable loss estimates.

(4) An evaluation of the appraisal

process of the underlying collateral.

This may be accomplished by

periodically comparing the appraised

value to the actual sales price on

selected properties sold.

Supporting Documentation for the

Validation Process

Management usually supports the

validation process with the workpapers

from the ALLL review function.

Additional documentation often

includes the summary findings of the

independent reviewer. The institution’s

board of directors, or its designee,

reviews the findings and acknowledges

its review in its meeting minutes. If the

methodology is changed based upon the

findings of the validation process,

documentation that describes and

supports the changes should be

maintained.

Appendix A—ALLL Questions and

Answers

Introduction

The Questions and Answers (Q&As)

presented in this appendix serve several

purposes, including (1) To illustrate the

banking agencies’ views, as set forth in this

Policy Statement, about the types of

decisions, determinations, and processes an

institution should document with respect to

its ALLL methodology and amounts; and (2)

to illustrate the types of ALLL documentation

and processes an institution might prepare,

retain, or use in a particular set of

circumstances. The level and types of

documentation described in the Q&As should

be considered neither the minimum

acceptable level of documentation nor an all-

inclusive list. Institutions are expected to

apply the guidance in this Policy Statement

to their individual facts, circumstances, and

situations

cumentation

and processes an institution might prepare,

retain, or use in a particular set of

circumstances. The level and types of

documentation described in the Q&As should

be considered neither the minimum

acceptable level of documentation nor an all-

inclusive list. Institutions are expected to

apply the guidance in this Policy Statement

to their individual facts, circumstances, and

situations. If an institution’s fact pattern

differs from the fact patterns incorporated in

the following Q&As, the institution may

decide to prepare and maintain different

types of documentation than did the

institutions depicted in these Q&As.

Q&A #1—ALLL Under FAS 114—Measuring

and Documenting Impairment

Facts: Approximately one-third of

Institution A’s commercial loan portfolio

consists of large balance, non-homogeneous

loans. Due to their large individual balances,

these loans meet the criteria under Institution

A’s policies and procedures for individual

review for impairment under FAS 114. Upon

review of the large balance loans, Institution

A determines that certain of the loans are

impaired as defined by FAS 114.

Question: For the commercial loans

reviewed under FAS 114 that are

individually impaired, how should

Institution A measure and document the

impairment on those loans? Can it use an

impairment measurement method other than

the methods allowed by FAS 114?

Interpretive Response: For those loans that

are reviewed individually under FAS 114

and considered individually impaired,

Institution A must use one of the methods for

measuring impairment that is specified by

FAS 114 (that is, the present value of

expected future cash flows, the loan’s

observable market price, or the fair value of

collateral). Accordingly, in the circumstances

described above, for the loans considered

individually impaired under FAS 114, it

would not be appropriate for Institution A to

choose a measurement method not

prescribed by FAS 114

s for

measuring impairment that is specified by

FAS 114 (that is, the present value of

expected future cash flows, the loan’s

observable market price, or the fair value of

collateral). Accordingly, in the circumstances

described above, for the loans considered

individually impaired under FAS 114, it

would not be appropriate for Institution A to

choose a measurement method not

prescribed by FAS 114. For example, it

would not be appropriate to measure loan

impairment by applying a loss rate to each

loan based on the average historical loss

percentage for all of its commercial loans for

the past five years.

Institution A should maintain, as

sufficient, objective evidence, written

documentation to support its measurement of

loan impairment under FAS 114. If

Institution A uses the present value of

expected future cash flows to measure

impairment of a loan, it should document the

amount and timing of cash flows, the

effective interest rate used to discount the

cash flows, and the basis for the

determination of cash flows, including

consideration of current environmental

factor 1 and other information reflecting past

events and current conditions. If Institution

A uses the fair value of collateral to measure

impairment, it should document how it

determined the fair value, including the use

of appraisals, valuation assumptions and

calculations, the supporting rationale for

adjustments to appraised values, if any, and

the determination of costs to sell, if

applicable, appraisal quality, and the

expertise and independence of the appraiser.

Similarly, Institution A should document the

amount, source, and date of the observable

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ing rationale for

adjustments to appraised values, if any, and

the determination of costs to sell, if

applicable, appraisal quality, and the

expertise and independence of the appraiser.

Similarly, Institution A should document the

amount, source, and date of the observable

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2 When reviewing collateral dependent loans,

Institution B may often find it more appropriate to

obtain an updated appraisal to estimate the effect

of current market conditions on the appraised value

instead of internally estimating an adjustment.

3 In accordance with the FFIEC’s Federal Register

Notice, Implementation Issues Arising from FASB

No. 114, ‘‘Accounting by Creditors for Impairment

of a Loan,’’ published February 10, 1995 (60 FR

7966, February 10, 1995), impaired, collateral-

dependent loans must be reported at the fair value

of collateral, less costs to sell, in regulatory reports.

This treatment is to be applied to all collateral-

dependent loans, regardless of type of collateral.

market price of a loan, if that method of

measuring loan impairment is used.

Q&A #2—ALLL Under FAS 114—Measuring

Impairment for a Collateral Dependent Loan

Facts: Institution B has a $10 million loan

outstanding to Company X that is secured by

real estate, which Institution B individually

evaluates under FAS 114 due to the loan’s

size. Company X is delinquent in its loan

payments under the terms of the loan

agreement. Accordingly, Institution B

determines that its loan to Company X is

impaired, as defined by FAS 114. Because

the loan is collateral dependent, Institution B

measures impairment of the loan based on

the fair value of the collateral

ate, which Institution B individually

evaluates under FAS 114 due to the loan’s

size. Company X is delinquent in its loan

payments under the terms of the loan

agreement. Accordingly, Institution B

determines that its loan to Company X is

impaired, as defined by FAS 114. Because

the loan is collateral dependent, Institution B

measures impairment of the loan based on

the fair value of the collateral. Institution B

determines that the most recent valuation of

the collateral was performed by an appraiser

eighteen months ago and, at that time, the

estimated value of the collateral (fair value

less costs to sell) was $12 million.

Institution B believes that certain of the

assumptions that were used to value the

collateral eighteen months ago do not reflect

current market conditions and, therefore, the

appraiser’s valuation does not approximate

current fair value of the collateral. Several

buildings, which are comparable to the real

estate collateral, were recently completed in

the area, increasing vacancy rates, decreasing

lease rates, and attracting several tenants

away from the borrower. Accordingly, credit

review personnel at Institution B adjust

certain of the valuation assumptions to better

reflect the current market conditions as they

relate to the loan’s collateral.2 After adjusting

the collateral valuation assumptions, the

credit review department determines that the

current estimated fair value of the collateral,

less costs to sell, is $8 million. Given that the

recorded investment in the loan is $10

million, Institution B concludes that the loan

is impaired by $2 million and records an

allowance for loan losses of $2 million.

Question: What type of documentation

should Institution B maintain to support its

determination of the allowance for loan

losses of $2 million for the loan to Company

X?

Interpretive Response: Institution B should

document that it measured impairment of the

loan to Company X by using the fair value

of the loan’s collateral, less costs to sell,

which it estimated to be $8 million

ses of $2 million.

Question: What type of documentation

should Institution B maintain to support its

determination of the allowance for loan

losses of $2 million for the loan to Company

X?

Interpretive Response: Institution B should

document that it measured impairment of the

loan to Company X by using the fair value

of the loan’s collateral, less costs to sell,

which it estimated to be $8 million. This

documentation should include the

institution’s rationale and basis for the $8

million valuation, including the revised

valuation assumptions it used, the valuation

calculation, and the determination of costs to

sell, if applicable. Because Institution B

arrived at the valuation of $8 million by

modifying an earlier appraisal, it should

document its rationale and basis for the

changes it made to the valuation assumptions

that resulted in the collateral value declining

from $12 million eighteen months ago to $8

million in the current period.3

Q&A #3—ALLL Under FAS 114—Fully

Collateralized Loans

Facts: Institution C has $10 million in

loans that are fully collateralized by highly

rated debt securities with readily

determinable market values. The loan

agreement for each of these loans requires the

borrower to provide qualifying collateral

sufficient to maintain a loan-to-value ratio

with sufficient margin to absorb volatility in

the securities’ market prices. Institution C’s

collateral department has physical control of

the debt securities through safekeeping

arrangements. In addition, Institution C

perfected its security interest in the collateral

when the funds were originally distributed.

On a quarterly basis, Institution C’s credit

administration function determines the

market value of the collateral for each loan

using two independent market quotes and

compares the collateral value to the loan

carrying value. If there are any collateral

deficiencies, Institution C notifies the

borrower and requests that the borrower

immediately remedy the deficiency

s were originally distributed.

On a quarterly basis, Institution C’s credit

administration function determines the

market value of the collateral for each loan

using two independent market quotes and

compares the collateral value to the loan

carrying value. If there are any collateral

deficiencies, Institution C notifies the

borrower and requests that the borrower

immediately remedy the deficiency. Due in

part to its efficient operation, Institution C

has historically not incurred any material

losses on these loans. Institution C believes

these loans are fully-collateralized and

therefore does not maintain any ALLL

balance for these loans.

Question: What documentation does

Institution C maintain to adequately support

its determination that no allowance is needed

for this group of loans?

Interpretive Response: Institution C’s

management summary of the ALLL includes

documentation indicating that, in accordance

with the institution’s ALLL policy, the

collateral protection on these loans has been

verified by the institution, no probable loss

has been incurred, and no ALLL is necessary.

Documentation in Institution C’s loan files

includes the two independent market quotes

obtained each quarter for each loan’s

collateral amount, the documents evidencing

the perfection of the security interest in the

collateral, and other relevant supporting

documents. Additionally, Institution C’s

ALLL policy includes a discussion of how to

determine when a loan is considered ‘‘fully

collateralized’’ and does not require an

ALLL. Institution C’s policy requires the

following factors to be considered and the

institution’s findings concerning these factors

to be fully documented:

(1) Volatility of the market value of the

collateral;

(2) Recency and reliability of the appraisal

or other valuation

(3) Recency of the institution’s or third

party’s inspection of the collateral

(4) Historical losses on similar loans;

(5) Confidence in the institution’s lien or

security position including appropriate:

nd the

institution’s findings concerning these factors

to be fully documented:

(1) Volatility of the market value of the

collateral;

(2) Recency and reliability of the appraisal

or other valuation

(3) Recency of the institution’s or third

party’s inspection of the collateral

(4) Historical losses on similar loans;

(5) Confidence in the institution’s lien or

security position including appropriate:

(a) Type of security perfection (e.g.,

physical possession of collateral or secured

filing);

(b) Filing of security perfection (i.e., correct

documents and with the appropriate

officials); and

(c) Relationship to other liens; and

(6) Other factors as appropriate for the loan

type.

Q&A #4—ALLL Under FAS 5—Adjusting

Loss Rates

Facts: Institution D’s lending area includes

a metropolitan area that is financially

dependent upon the profitability of a number

of manufacturing businesses. These

businesses use highly specialized equipment

and significant quantities of rare metals in

the manufacturing process. Due to increased

low-cost foreign competition, several of the

parts suppliers servicing these manufacturing

firms declared bankruptcy. The foreign

suppliers have subsequently increased prices

and the manufacturing firms have suffered

from increased equipment maintenance costs

and smaller profit margins. Additionally, the

cost of the rare metals used in the

manufacturing process increased and has

now stabilized at double last year’s price.

Due to these events, the manufacturing

businesses are experiencing financial

difficulties and have recently announced

downsizing plans.

Although Institution D has yet to confirm

an increase in its loss experience as a result

of these events, management knows that it

lends to a significant number of businesses

and individuals whose repayment ability

depends upon the long-term viability of the

manufacturing businesses

, the manufacturing

businesses are experiencing financial

difficulties and have recently announced

downsizing plans.

Although Institution D has yet to confirm

an increase in its loss experience as a result

of these events, management knows that it

lends to a significant number of businesses

and individuals whose repayment ability

depends upon the long-term viability of the

manufacturing businesses. Institution D’s

management has identified particular

segments of its commercial and consumer

customer bases that include borrowers highly

dependent upon sales or salary from the

manufacturing businesses. Institution D’s

management performs an analysis of the

affected portfolio segments to adjust its

historical loss rates used to determine the

ALLL. In this particular case, Institution D

has experienced similar business and lending

conditions in the past that it can compare to

current conditions.

Question: How should Institution D

document its support for the loss rate

adjustments that result from considering

these manufacturing firms’ financial

downturns?

Interpretive Response: Institution D should

document its identification of the particular

segments of its commercial and consumer

loan portfolio for which it is probable that

the manufacturing business’ financial

downturn has resulted in loan losses. In

addition, Institution D should document its

analysis that resulted in the adjustments to

the loss rates for the affected portfolio

segments. As part of its documentation,

Institution D maintains copies of the

documents supporting the analysis,

including relevant newspaper articles,

economic reports, economic data, and notes

from discussions with individual borrowers.

Because in this case Institution D has had

similar situations in the past, its supporting

documentation also includes an analysis of

how the current conditions compare to its

previous loss experiences in similar

circumstances

copies of the

documents supporting the analysis,

including relevant newspaper articles,

economic reports, economic data, and notes

from discussions with individual borrowers.

Because in this case Institution D has had

similar situations in the past, its supporting

documentation also includes an analysis of

how the current conditions compare to its

previous loss experiences in similar

circumstances. As part of its effective ALLL

methodology, Institution D creates a

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4 These groups of loans do not include any loans

that have been individually reviewed for

impairment under FAS 114 and determined to be

impaired as defined by FAS 114.

1 This Appendix provides guidance on the ALLL

and does not address allowances for credit losses

for off-balance sheet instruments (e.g., loan

commitments, guarantees, and standby letters of

credit). Institutions should record liabilities for

these exposures in accordance with GAAP. Further

guidance on this topic is presented in the American

Institute of Certified Public Accountants’ Audit and

Accounting Guide, Banks and Savings Institutions,

2000 edition (AICPA Audit Guide). Additionally,

this Appendix does not address allowances or

accounting for assets or portions of assets sold with

recourse, which is described in Statement of

Financial Accounting Standards No. 140,

Accounting for Transfers and Servicing of Financial

Assets and Extinguishments of Liabilities—a

Replacement of FASB Statement No. 125 (FAS 140).

2 Refer to FASB Interpretation No. 14, Reasonable

Estimation of the Amount of a Loss, and Emerging

Issues Task Force Topic No. D–80, Application of

FASB Statements No. 5 and No. 114 to a Loan

Portfolio (EITF Topic D–80).

3 EITF Topic D–80 includes additional guidance

on the requirements of FAS 5 and FAS 114 and how

they relate to each other

lities—a

Replacement of FASB Statement No. 125 (FAS 140).

2 Refer to FASB Interpretation No. 14, Reasonable

Estimation of the Amount of a Loss, and Emerging

Issues Task Force Topic No. D–80, Application of

FASB Statements No. 5 and No. 114 to a Loan

Portfolio (EITF Topic D–80).

3 EITF Topic D–80 includes additional guidance

on the requirements of FAS 5 and FAS 114 and how

they relate to each other. The AICPA is currently

developing a Statement of Position (SOP) that will

provide more specific guidance on accounting for

loan losses.

summary of the amount and rationale for the

adjustment factor, which management

presents to the audit committee and board for

their review and approval prior to the

issuance of the financial statements.

Q&A #5—ALLL Under FAS 5—Estimating

Losses on Loans Individually Reviewed for

Impairment But Not Considered Individually

Impaired

Facts: Institution E has outstanding loans

of $2 million to Company Y and $1 million

to Company Z, both of which are paying as

agreed upon in the loan documents. The

institution’s ALLL policy specifies that all

loans greater than $750,000 must be

individually reviewed for impairment under

FAS 114. Company Y’s financial statements

reflect a strong net worth, good profits, and

ongoing ability to meet debt service

requirements. In contrast, recent information

indicates Company Z’s profitability is

declining and its cash flow is tight.

Accordingly, this loan is rated substandard

under the institution’s loan grading system.

Despite its concern, management believes

Company Z will resolve its problems and

determines that neither loan is individually

impaired as defined by FAS 114.

Institution E segments its loan portfolio to

estimate loan losses under FAS 5. Two of its

loan portfolio segments are Segment 1 and

Segment 2

w is tight.

Accordingly, this loan is rated substandard

under the institution’s loan grading system.

Despite its concern, management believes

Company Z will resolve its problems and

determines that neither loan is individually

impaired as defined by FAS 114.

Institution E segments its loan portfolio to

estimate loan losses under FAS 5. Two of its

loan portfolio segments are Segment 1 and

Segment 2. The loan to Company Y has risk

characteristics similar to the loans included

in Segment 1 and the loan to Company Z has

risk characteristics similar to the loans

included in Segment 2.4

In its determination of the ALLL under

FAS 5, Institution E includes its loans to

Company Y and Company Z in the groups of

loans with similar characteristics (i.e.,

Segment 1 for Company Y’s loan and

Segment 2 for Company Z’s loan).

Management’s analyses of Segment 1 and

Segment 2 indicate that it is probable that

each segment includes some losses, even

though the losses cannot be identified to one

or more specific loans. Management

estimates that the use of its historical loss

rates for these two segments, with

adjustments for changes in environmental

factors provides a reasonable estimate of the

institution’s probable loan losses in these

segments.

Question: How does Institution E

adequately document an ALLL under FAS 5

for these loans that were individually

reviewed for impairment but are not

considered individually impaired?

Interpretive Response: As part of

Institution E’s effective ALLL methodology, it

documents the decision to include its loans

to Company Y and Company Z in its

determination of its ALLL under FAS 5. It

also documents the specific characteristics of

the loans that were the basis for grouping

these loans with other loans in Segment 1

and Segment 2, respectively

e not

considered individually impaired?

Interpretive Response: As part of

Institution E’s effective ALLL methodology, it

documents the decision to include its loans

to Company Y and Company Z in its

determination of its ALLL under FAS 5. It

also documents the specific characteristics of

the loans that were the basis for grouping

these loans with other loans in Segment 1

and Segment 2, respectively. Institution E

maintains documentation to support its

method of estimating loan losses for Segment

1 and Segment 2, including the average loss

rate used, the analysis of historical losses by

loan type and by internal risk rating, and

support for any adjustments to its historical

loss rates. The institution also maintains

copies of the economic and other reports that

provided source data.

Q&A #6—Consolidating the Loss Estimates—

Documenting the Reported ALLL

Facts: Institution F determines its ALLL

using an established systematic process. At

the end of each period, the accounting

department prepares a summary schedule

that includes the amount of each of the

components of the ALLL, as well as the total

ALLL amount, for review by senior

management, the Credit Committee, and,

ultimately, the board of directors. Members

of senior management and the Credit

Committee meet to discuss the ALLL. During

these discussions, they identify changes that

are required by GAAP to be made to certain

of the ALLL estimates. As a result of the

adjustments made by senior management, the

total amount of the ALLL changes. However,

senior management (or its designee) does not

update the ALLL summary schedule to

reflect the adjustments or reasons for the

adjustments. When performing their audit of

the financial statements, the independent

accountants are provided with the original

ALLL summary schedule that was reviewed

by senior management and the Credit

Committee, as well as a verbal explanation of

the changes made by senior management and

the Credit Committee when they met to

discuss the loan loss allowance

ct the adjustments or reasons for the

adjustments. When performing their audit of

the financial statements, the independent

accountants are provided with the original

ALLL summary schedule that was reviewed

by senior management and the Credit

Committee, as well as a verbal explanation of

the changes made by senior management and

the Credit Committee when they met to

discuss the loan loss allowance.

Question: Are Institution F’s

documentation practices related to the

balance of its loan loss allowance in

compliance with existing documentation

guidance in this area?

Interpretive Response: No. An institution

must maintain supporting documentation for

the loan loss allowance amount reported in

its financial statements. As illustrated above,

there may be instances in which ALLL

reviewers identify adjustments that need to

be made to the loan loss estimates. The

nature of the adjustments, how they were

measured or determined, and the underlying

rationale for making the changes to the ALLL

balance should be documented. Appropriate

documentation of the adjustments should be

provided to the board of directors (or its

designee) for review of the final ALLL

amount to be reported in the financial

statements. For institutions subject to

external audit, this documentation should

also be made available to the independent

accountants. If changes frequently occur

during management or credit committee

reviews of the ALLL, management may find

it appropriate to analyze the reasons for the

frequent changes and to reassess the

methodology the institution uses.

Appendix B—Application of GAAP

An ALLL recorded pursuant to GAAP is an

institution’s best estimate of the probable

amount of loans and lease-financing

receivables that it will be unable to collect

based on current information and events.1 A

creditor should record an ALLL when the

criteria for accrual of a loss contingency as

set forth in GAAP have been met. Estimating

the amount of an ALLL involves a high

degree of management judgment and is

inevitably imprecise

s an

institution’s best estimate of the probable

amount of loans and lease-financing

receivables that it will be unable to collect

based on current information and events.1 A

creditor should record an ALLL when the

criteria for accrual of a loss contingency as

set forth in GAAP have been met. Estimating

the amount of an ALLL involves a high

degree of management judgment and is

inevitably imprecise. Accordingly, an

institution may determine that the amount of

loss falls within a range. An institution

should record its best estimate within the

range of loan losses.2

Under GAAP, Statement of Financial

Accounting Standards No. 5, Accounting for

Contingencies (FAS 5), provides the basic

guidance for recognition of a loss

contingency, such as the collectibility of

loans (receivables), when it is probable that

a loss has been incurred and the amount can

be reasonably estimated. Statement of

Financial Accounting Standards No. 114,

Accounting by Creditors for Impairment of a

Loan (FAS 114) provides more specific

guidance about the measurement and

disclosure of impairment for certain types of

loans.3 Specifically, FAS 114 applies to loans

that are identified for evaluation on an

individual basis. Loans are considered

impaired when, based on current information

and events, it is probable that the creditor

will be unable to collect all interest and

principal payments due according to the

contractual terms of the loan agreement.

For individually impaired loans, FAS 114

provides guidance on the acceptable methods

to measure impairment. Specifically, FAS

114 states that when a loan is impaired, a

creditor should measure impairment based

on the present value of expected future

principal and interest cash flows discounted

at the loan’s effective interest rate, except

that as a practical expedient, a creditor may

measure impairment based on a loan’s

observable market price or the fair value of

collateral, if the loan is collateral dependent

ally, FAS

114 states that when a loan is impaired, a

creditor should measure impairment based

on the present value of expected future

principal and interest cash flows discounted

at the loan’s effective interest rate, except

that as a practical expedient, a creditor may

measure impairment based on a loan’s

observable market price or the fair value of

collateral, if the loan is collateral dependent.

When developing the estimate of expected

future cash flows for a loan, an institution

should consider all available information

reflecting past events and current conditions,

including the effect of existing environmental

factors. The following Illustration provides

an example of an institution estimating a

loan’s impairment when the loan has been

partially charged-off.

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35639

Federal Register / Vol. 66, No. 130 / Friday, July 6, 2001 / Notices

4 In addition, FAS 114 does not apply to loans

measured at fair value or at the lower of cost or fair

value, leases, or debt securities.

5 According to the Federal Financial Institutions

Examination Council’s Federal Register Notice,

Implementation Issues Arising from FASB

Statement No. 114, Accounting by Creditors for

Impairment of a Loan, published February 10, 1995,

institution-specific issues should be reviewed when

estimating loan losses under FAS 114. This analysis

should be conducted as part of the evaluation of

each individual loan reviewed under FAS 114 to

avoid potential ALLL layering.

6 Refer to paragraph 7.05 of the AICPA Audit

Guide.

7 Institutions should refer to the guidance on

materiality in SEC Staff Accounting Bulletin No. 99,

Materiality.

Begin Text Box—Illustration (Interaction of

FAS 114 With an Adversely Classified Loan,

Partial Charge-off, and the Overall ALLL): An

institution determined that a collateral

dependent loan, which it identified for

evaluation, was impaired

efer to paragraph 7.05 of the AICPA Audit

Guide.

7 Institutions should refer to the guidance on

materiality in SEC Staff Accounting Bulletin No. 99,

Materiality.

Begin Text Box—Illustration (Interaction of

FAS 114 With an Adversely Classified Loan,

Partial Charge-off, and the Overall ALLL): An

institution determined that a collateral

dependent loan, which it identified for

evaluation, was impaired. In accordance with

FAS 114, the institution established an ALLL

for the amount that the recorded investment

in the loan exceeded the fair value of the

underlying collateral, less costs to sell.

Consistent with relevant regulatory guidance,

the institution classified as ‘‘Loss,’’ the

portion of the recorded investment deemed

to be the confirmed loss and classified the

remaining recorded investment as

‘‘Substandard.’’ For this loan, the amount

classified ‘‘Loss’’ was less than the

impairment amount (as determined under

FAS 114). The institution charged off the

‘‘Loss’’ portion of the loan. After the charge-

off, the portion of the ALLL related to this

‘‘Substandard’’ loan (1) reflects an

appropriate measure of impairment under

FAS 114, and (2) is included in the aggregate

FAS 114 ALLL for all loans that were

identified for evaluation and individually

considered impaired. The aggregate FAS 114

ALLL is included in the institution’s overall

ALLL. End Text Box

Large groups of smaller-balance

homogeneous loans that are collectively

evaluated for impairment are not included in

the scope of FAS 114.4 Such groups of loans

may include, but are not limited to, credit

card, residential mortgage, and consumer

installment loans. FAS 5 addresses the

accounting for impairment of these loans.

Also, FAS 5 provides the accounting

guidance for impairment of loans that are not

identified for evaluation on an individual

basis and loans that are individually

evaluated but are not individually considered

impaired.

Institutions should ensure that they do not

layer their loan loss allowances

mortgage, and consumer

installment loans. FAS 5 addresses the

accounting for impairment of these loans.

Also, FAS 5 provides the accounting

guidance for impairment of loans that are not

identified for evaluation on an individual

basis and loans that are individually

evaluated but are not individually considered

impaired.

Institutions should ensure that they do not

layer their loan loss allowances. Layering is

the inappropriate practice of recording in the

ALLL more than one amount for the same

probable loan loss. Layering can happen

when an institution includes a loan in one

segment, determines its best estimate of loss

for that loan either individually or on a group

basis (after taking into account all

appropriate environmental factors,

conditions, and events), and then includes

the loan in another group, which receives an

additional ALLL amount.5

While different institutions may use

different methods, there are certain common

elements that should be included in any loan

loss allowance methodology. Generally, an

institution’s methodology should:6

(1) Include a detailed analysis of the loan

portfolio, performed on a regular basis;

(2) Consider all loans (whether on an

individual or group basis);

(3) Identify loans to be evaluated for

impairment on an individual basis under

FAS 114 and segment the remainder of the

portfolio into groups of loans with similar

risk characteristics for evaluation and

analysis under FAS 5;

(4) Consider all known relevant internal

and external factors that may affect loan

collectibility;

(5) Be applied consistently but, when

appropriate, be modified for new factors

affecting collectibility;

(6) Consider the particular risks inherent in

different kinds of lending;

(7) Consider current collateral values (less

costs to sell), where applicable;

(8) Require that analyses, estimates,

reviews and other ALLL methodology

functions be performed by competent and

well-trained personnel;

(9) Be based on current and reliable data;

appropriate, be modified for new factors

affecting collectibility;

(6) Consider the particular risks inherent in

different kinds of lending;

(7) Consider current collateral values (less

costs to sell), where applicable;

(8) Require that analyses, estimates,

reviews and other ALLL methodology

functions be performed by competent and

well-trained personnel;

(9) Be based on current and reliable data;

(10) Be well documented, in writing, with

clear explanations of the supporting analyses

and rationale; and

(11) Include a systematic and logical

method to consolidate the loss estimates and

ensure the ALLL balance is recorded in

accordance with GAAP.

A systematic methodology that is properly

designed and implemented should result in

an institution’s best estimate of the ALLL.

Accordingly, institutions should adjust their

ALLL balance, either upward or downward,

in each period for differences between the

results of the systematic determination

process and the unadjusted ALLL balance in

the general ledger.7

Bibliography

American Institute of Certified Public

Accountants’ Audit and Accounting Guide,

Banks and Savings Institutions, 2000

edition

Auditing Standards Board Statement on

Auditing Standards No. 61,

Communication With Audit Committees

(AICPA, Professional Standards, vol. 1, AU

sec. 380)

Emerging Issues Task Force Topic No. D–80,

Application of FASB Statements No. 5 and

No. 114 to a Loan Portfolio (EITF Topic D–

80 and attachments), discussed on May 19–

20, 1999

Financial Accounting Standards Board

Interpretation No. 14, Reasonable

Estimation of the Amount of a Loss (An

Interpretation of FASB Statement No. 5)

Financial Accounting Standards Board

Statement of Financial Accounting

Standards No. 5, Accounting for

Contingencies

Federal Deposit Insurance Act, Section 39,

Standards for Safety and Soundness (12

U.S.C

d attachments), discussed on May 19–

20, 1999

Financial Accounting Standards Board

Interpretation No. 14, Reasonable

Estimation of the Amount of a Loss (An

Interpretation of FASB Statement No. 5)

Financial Accounting Standards Board

Statement of Financial Accounting

Standards No. 5, Accounting for

Contingencies

Federal Deposit Insurance Act, Section 39,

Standards for Safety and Soundness (12

U.S.C. 1831p–1)

Federal Financial Institutions Examination

Council’s Instructions for Preparation of

Consolidated Reports of Condition and

Income

Financial Accounting Standards Board

Statement of Financial Accounting

Standards No. 114, Accounting by

Creditors for Impairment of A Loan (An

Amendment of FASB Statements No. 5 and

15)

Financial Accounting Standards Board

Statement of Financial Accounting

Standards No. 118, Accounting by

Creditors for Impairment of a Loan—

Income Recognition and Disclosures (An

Amendment of FASB Statement No. 114)

Financial Accounting Standards Board

Statement of Financial Accounting

Standards No. 140, Accounting for

Transfers and Servicing of Financial Assets

and Extinguishments of Liabilities—a

Replacement of FASB Statement No. 125

Interagency Guidelines Establishing

Standards for Safety and Soundness,

established in 1995 and 1996, as amended

on October 15, 1998

Interagency Policy Statement on the

Allowance for Loan and Lease Losses

(ALLL), December 21, 1993

Joint Interagency Statement (regarding the

ALLL), November 24, 1998

Joint Interagency Letter to Financial

Institutions (regarding the ALLL), March

10, 1999

Joint Interagency Letter to Financial

Institutions (regarding the ALLL), July 12,

1999

Securities and Exchange Commission

Financial Reporting Release No. 28,

Accounting for Loan Losses by Registrants

Engaged in Lending Activities, December

1, 1986

Securities and Exchange Commission

Securities Act Industry Guide 3, Statistical

Disclosure by Bank Holding Companies

Securities and Exchange Commission Staff

Accounting Bulletin No

Financial

Institutions (regarding the ALLL), July 12,

1999

Securities and Exchange Commission

Financial Reporting Release No. 28,

Accounting for Loan Losses by Registrants

Engaged in Lending Activities, December

1, 1986

Securities and Exchange Commission

Securities Act Industry Guide 3, Statistical

Disclosure by Bank Holding Companies

Securities and Exchange Commission Staff

Accounting Bulletin No. 99, Materiality,

August 1999

Securities Exchange Act of 1934, Section

13(b)(2)–(7) (15 U.S.C. 78m(b)(2)–(7))

United States General Accounting Office

Report to Congressional Committees,

Depository Institutions: Divergent Loan

Loss Methods Undermine Usefulness of

Financial Reports, (GAO/AIMD–95–8),

October 1994

Dated: July 2, 2001.

Keith J. Todd,

Executive Secretary, Federal Financial

Institutions Examination Council.

[FR Doc. 01–16973 Filed 7–5–01; 8:45 am]

BILLING CODES 6710–01–P; 6714–01–P; 6720–01–P;

4810–33–P

FEDERAL RESERVE SYSTEM

Formations of, Acquisitions by, and

Mergers of Bank Holding Companies

The companies listed in this notice

have applied to the Board for approval,

pursuant to the Bank Holding Company

Act of 1956 (12 U.S.C. 1841 et seq.)

(BHC Act), Regulation Y (12 CFR part

225), and all other applicable statutes

and regulations to become a bank

holding company and/or to acquire the

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