Components of the ALLL – Breaking down the assumptions

by Twenty Twenty

by. Dan Price

Calculating your allowance for loan losses involves projecting future results using historical information as a baseline. Why does this seem counter intuitive to everything we’ve learned?

Anyone presenting historical information should tell you that historical data is not necessarily indicative of future results. Our best guess on future loss reserves involve adjusting that historical information to account for changes between then and now. The primary assumptions used to do this involve the level of disaggregation, the duration of historical charge offs to use and evaluating the effect of qualitative characteristics.

FAS 5 instructs financial institutions to separate loans into homogeneous, or similar groups. Differences in interest rate, duration, collateralization and individual borrower characteristics make calling any two loans homogeneous feel like a stretch. So the question is, how much should you actually break your portfolio down in your allowance calculation?

You could think up 100 different ways to calculate your allowance for loan losses and 95 of them would be within 20% of one another. The margin of error should be smaller for larger loan portfolios (See: sample size) but you shouldn’t expect to consistently do much better than +/- 10-20%.

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