by: Mike Lubansky, Senior Financial Analyst, Sageworks, Inc.
Between increased regulatory scrutiny and the challenges of defending the estimation to regulators, external auditors, and the board, many credit unions find themselves overwhelmed with the process of estimating and documenting the Allowance for Loan and Lease Losses (ALLL) each month or quarter.
The ALLL estimation is significant in that regulators are vigilant about ensuring that credit unions have enough in their reserves, but the estimation is also significant in its impact on an institution’s earnings and capital.
Some of the most significant challenges that credit unions face with regard to employing a comprehensive, systematic, and consistently applied process include:
1. The manual, time-intensive nature of the process each month or quarter. For many credit unions, the process can take several days if not more for various finance, credit, and/ or lending staff. Some individuals are high-level executives whose time is at a premium, so the greater amount of time directed toward the ALLL can be a burden. This process is labor intensive, manual, and often prone to error, through the use of an assortment of Excel spreadsheets, which can lead to version control issues and formula errors, amongst other issues.
Linda Keith CPA, a consultant on loan analysis and credit union education sees a new wrinkle to the time challenge of ALLL. “As we pull out of the recession, many credit unions must increase loan volume for sustained profitability and adequate capitalization. When the same personnel are responsible for approval of loan originations as well as for periodic review of existing loans for impairment, the time to do both well is at a premium. Even credit unions that are comfortable their methodology provides for an accurate allowance are looking for ways to streamline the analysis and the reporting.”
2. Keeping up with new accounting standards and regulatory demands. The credit union must stay current not only with the published regulatory guidance, but also with new accounting standards being issued from FASB, as well as the regulatory demands from the institution’s specific regulators, which may or may not coincide precisely with the two aforementioned sets of standards.
3. Additional reporting and disclosure requirements as well as increased scrutiny on the assumptions used to determine the general reserves. In recent years, FASB has continued to issue new requirements through its Accounting Standards Updates. While these often consist of simple reports and aggregation of data that is already in use, it can be time-consuming and place additional strain on limited resources.
4. Increased scrutiny on the assumptions used to determine the general reserves. This includes questions about how to appropriately segment the pools, assumptions used for the number of periods of historical data to include for establishment of the Historical Loss Reserve portion of the general reserves, and the judgment and defense of qualitative factor adjustments in the assessment of the general reserves.
5. Increased scrutiny around the specific reserves for impaired loans. This includes the appropriate determination of which loans need to be evaluated for impairment, determination of whether the loan should be considered “collateral-dependent” and evaluated under the “Fair Market Value of Collateral” method or under the “Present Value of Future Cash Flows”, and the correct assumptions to employ in either method.
Nelson Reeves from Reeves Risk Management, a firm serving financial institutions in the Southeastern U.S., sums up these challenges by stating: “Overall, one of the most significant challenges is arriving at an amount in the allowance which both adheres to the accounting and regulatory requirements and satisfies the regulators as to its adequacy.”
Such challenges require a systematic approach in which the institution carefully examines the impact of their loan policies, and implements a structured approach to evaluating the losses inherent in their portfolio. Current spreadsheets and policies may or may not be adequate to meet these demands. Any efforts to streamline the process and better document the credit union’s assumptions are beneficial in defending the estimation of the Allowance in a comprehensive manner.
Mike Lubansky is Senior Financial Analyst and Product Manager at Sageworks where he oversees product development, market research, and implementation in the financial institutions market. Before joining Sageworks in 2009, Mr. Lubansky served as Research Analyst for the Cherry Hills Fund and as Financial Analyst for Humana. Mr. Lubansky’s analysis has been published by media outlet such as Forbes, American Banker, and CNBC. Mr. Lubansky received his MBA with concentrations in Finance and Entrepreneurship from the University of North Carolina-Chapel Hill and his BA in American Studies from Yale University. www.sageworksinc.com