BACKGROUND
This Bulletin provides guidance for establishing and maintaining the allowance for loan and lease losses (Allowance), one of the most important items affecting credit unions. The Allowance should result in a fair presentation of financial statements in conformity with generally accepted accounting principles (GAAP) and meet regulatory requirements for full and fair disclosure. Because of the importance of this issue, the Department believes credit unions must have clear and consistent guidelines to follow.
The Allowance is a valuation reserve established and maintained by charges against the credit union’s operating income. As a valuation reserve, it is an estimate of uncollectible amounts that is used to reduce the book value of loans and leases to the amount that is expected to be collected.
Credit unions must establish an Allowance because there is credit risk in all loan and lease portfolios. The Allowance exists to cover the loan losses that occur in the loan portfolio of every credit union. As such, adequate management of the Allowance is an integral part of a credit union’s credit risk management process.
PURPOSE OF THE ALLOWANCE
The Allowance is a valuation reserve maintained to cover losses that are probable and estimable on the date of the evaluation. The Allowance is not a cushion against possible future losses; that protection is provided by other reserves
Although portions of the Allowance can be attributed to or based upon the inherent losses in individual loans and categories of similar loans, the Allowance is a general reserve available to absorb all credit losses that arise from the entire portfolio. No part of the Allowance should be officially segregated for, or allocated to, any particular asset or group of assets.
ESTABLISHING AN ADEQUATE ALLOWANCE
Every credit union must have a program to establish and regularly review the adequacy of its Allowance. The Allowance must be maintained at a level that is adequate to absorb all estimated inherent losses in the loan and lease portfolio as of its evaluation date. A credit union that fails to maintain an adequate Allowance is operating in an unsafe and unsound manner.
The Allowance must cover inherent losses in all outstanding loans and leases. The Allowance should also reflect all significant, existing conditions affecting the ability of members to repay. The availability of credit union income, whether ordinary or nonrecurring, should not be a factor in determining an appropriate level for the Allowance.
Recognizing Problem Loans
To establish an adequate Allowance, a credit union must be able to recognize when loans have become a problem. An effective review system and controls that identify, monitor, and manage asset quality problems in an accurate and timely manner are essential. Accordingly, each credit union shall maintain written policies approved by its board of directors that establish the necessary systems and controls. The policies shall specifically set forth the manner in which the loan and lease portfolio will be reviewed and analyzed to ensure compliance with the applicable requirements and the timely charge-off of loans, or portions of loans, when a loss has been confirmed.
To be effective, a review system must respond not only to the obvious indicators of a problem, such as delinquency. It should also recognize, to the extent practical and possible, more subtle warnings of conditions that may affect the ability of members to repay on a timely basis, such as deterioration in a member’s financial condition or adverse market developments.
Regardless of whether a loan is unsecured or collateralized, credit unions must promptly charge off the amount of any confirmed loan loss. For unsecured loans, bankruptcy or protracted delinquency may confirm the fact of a loss and require a charge-off. For troubled, collateral-dependent loans, loss confirming events may include an appraisal or other valuation that reflects a shortfall between the value of the collateral and the book value of the loan, or a deficiency balance following the sale of the collateral.
Estimating Inherent Losses
Estimated inherent losses should reflect consideration of all significant factors that affect collectability of the loans and leases as of the evaluation date. While either historical loss experience or migration analysis may provide a reasonable starting point, it is not, by itself, a sufficient basis to determine an adequate level. Management should also consider any factors that are likely to cause estimated losses to differ from historical loss experience or migration analysis, including but not limited to:
- Changes in lending policies and procedures, including underwriting, collection, charge-off, and recovery practices.
- Changes in local economic or business conditions.
- Changes in the volume or type of credit extended.
- Changes in the experience, ability, and depth of lending personnel.
- Changes in the volume or severity of past due, restructured, or classified loans.
- Changes in the quality of a credit union’s loan review system or the degree of oversight by the board of directors.
- The existence of, or changes in the level of, any concentrations of credit.
Credit unions are also encouraged to use ratio analysis as a supplemental check for evaluating the overall reasonableness of the Allowance. Ratio analysis can be useful in identifying trends in the relationship of the Allowance to classified loans, to past due loans, to total loans and leases, and to historical charge-off levels. However, while such comparison can be helpful as a supplemental check of the reasonableness of the credit union’s assumptions and analysis, they are not, by themselves, a sufficient basis for determining an adequate reserve level. Such comparisons do not eliminate the need for an analysis of the loan and lease portfolio and the factors affecting its collectability.
One of the Department’s examination objectives is to evaluate the soundness of the credit union’s Allowance determination process. Much of what follows in this bulletin is devoted to a discussion of an analytical framework for estimating inherent losses and an adequate level for the Allowance.
Provisions for Individual Classified Loans
The classification of a loan reflects a judgment about the risks of default and loss associated with the loan. Loans have inherent loss when existing facts, conditions, and values suggest it is probable that the credit union will not collect some or all of its exposure to the member. The provision to the Allowance for loans analyzed individually must be sufficient to cover the inherent loss present as of the evaluation date.
The Allowance provision for all individually analyzed loans must be based on a reasonable and well documented estimate of the amount of the loss involved. Credit unions must document the rationale and justification for individually analyzed loans that are provided for at a rate that is below the historical loss rate for similar loans. Decisions to diverge from the credit union’s historical experience for loans must be clearly supported by the nature of the collateral or other circumstances that distinguish the loan from similarly classified loans.
In some cases, it may not be practical or necessary for credit unions to analyze and provide for their smaller consumer loans on an individual, loan-by-loan basis. Instead, credit unions may provide for such credits as part of a pool of similar loans using historical loss experience for such loans, adjusted for current conditions.
Loans that are analyzed as part of a pool are subject to the same loss events as loans that are analyzed individually. The most common indicator of inherent loss in pools of loans is delinquency. Examples of other loss events are loss of a job, divorce, bankruptcy, or death.
Loss confirming events should cause the Allowance to be increased to reflect the potential loss estimate for these problem loans. For consumer loans, those events will be typically based on the thresholds established in Table 1, rather than by specific adverse information about the member. Of course, if a credit union receives adverse, member-specific information confirming the loss before a threshold date has passed, the Allowance should be adjusted immediately. All credit unions should be aware that the Department no longer considers the 10-40-90 ratio to be a valid estimate of the loss exposure for problem loans.
Loans that have been individually analyzed and provided for in the Allowance should also be included in their respective pools of similar loans when determining the credit union’s historical loss experience on such loans. To avoid double counting of the inherent losses, however, loans that have been provided for individually should be subtracted from the pool of loans before the historical loss factor is applied to the pool to establish the appropriate provision for the pool.
METHODOLOGIES FOR ANALYZING THE LOAN PORTFOLIO
Because no single approach has been determined to be the best, or appropriate, for all credit unions, the Department does not require that credit unions use a specific method to determine loss experience. The method a credit union uses will depend to a large degree upon the capabilities of its information systems. Acceptable methods range from a simple average of the credit union’s loss experience over a period of years, to more complex “migration” analysis techniques.
In principle, the goal of any allowance methodology that applies loss experience to the current portfolio should be to provide for unconfirmed losses that probably exist as of the evaluation date. How that is accomplished, including the analysis time frames used, will depend upon the characteristics of the portfolio and the particular methodology.
Historical Analysis Periods
There is no fixed, historical period of time that should be analyzed by credit unions to determine average historical loss experience. During periods of economic stability in the credit union’s markets, a relatively long period of time (e.g., five years) may be appropriate. However, during periods of significant economic expansion or contraction, the credit union may appropriately shorten the historical time period considered in order to more accurately estimate the credit union’s inherent losses in the current economic climate. Alternatively, the credit union’s analysis may weigh recent experience more heavily.
Migration Analysis
Migration analysis techniques, which vary widely between credit unions, are usually and most appropriately applied to pools of past due and/or classified loans. The past due and/or classified status of these loans are indicative of the fact that a loss event may or will likely occur.
The most basic forms of migration analysis focus on the classification history of a fixed population of loans that are ultimately charged off. More sophisticated forms of migration analysis track the loss experience on a rolling population of loans over a period of several years and involve the collection and analysis of a very large volume of historical data. Some of the most sophisticated analyses may factor in differences in underwriting standards between different “vintages” of loans, the geographic and demographic attributes of the loans, or the relative seasoning of the loans (e.g., variations in loss rates between auto loans that are less than one year old compared to more seasoned auto loans).
Like the historical average approach, the purpose of a migration analysis is simply to determine, based on the credit union’s experience over a historical analysis period, what rate of loss the credit union has incurred on similarly criticized or past due loans. Generally speaking, if the migration analysis is being done on a fixed pool of loans, the analysis time frame should cover the resolution of all loans in the pool (i.e., the time period over which the loans are either paid off, returned to performing status, or charged off). If it is a rolling analysis, the analysis time frame typically covers a much longer period.
MANAGEMENT’S RESPONSIBILITY FOR THE ALLOWANCE
Credit union management must evaluate the adequacy of the Allowance prior to the distribution or posting of any dividends and convey its findings to the board of directors. Regulatory reports and other financial statements must accurately reflect the operating results and financial condition of the credit union for the reporting period. A significant misstated Allowance misrepresents the credit union’s financial condition on its report of condition and income and is misconduct under Section 122.255 of the Texas Finance Code.
The credit union must document its evaluation process sufficiently to establish that the methods used and the factors considered by the credit union provide a satisfactory basis for determining an adequate level for the Allowance. At a minimum, the credit union must document the bases for provisions for individually analyzed loans and for either the historical loss percentages or the migration analysis used for the portfolio (including any subjective adjustments for current conditions). If large or unusual provisions are made to the Allowance, the credit union should be able to document that the need for the provision arose in the current period and did not result from inadequate provisions in prior periods.
EXAMINERS’ REVIEW OF THE CREDIT UNION’S PROCESS
While credit unions are responsible for determining an adequate Allowance and adopting a reasonable methodology for doing so, the Department is responsible for reviewing the credit union’s Allowance evaluation process and testing the adequacy of the Allowance balance. Examiners should accept management’s estimates of an adequate level for the Allowance if the following conditions are satisfied:
- The credit union has maintained effective systems and controls for identifying, monitoring, and addressing asset quality problems in a timely manner; and
- The credit union has established an acceptable Allowance evaluation process that analyzes in a reasonable manner all significant factors that affect the collectability of the portfolio.
However, if the credit union’s Allowance evaluation process is deficient or is based on the results of an unreliable review system, the examiner will have to prepare an estimate of the amount of an appropriate Allowance, based on available information. The examiner’s estimate should be based on an analysis of the credit union’s portfolio using the following test as a guideline. While this method may produce results that approximate an acceptable Allowance under GAAP, it tends to be conservative, so care must be taken in interpreting the results.
- Review each delinquent or nonperforming loan and selected large loans and determine the amounts that are losses or doubtful of collection. Refinancing and extension agreements without adequate payment history would be considered nonperforming. Add together the anticipated loss amount for each loan.
- Compute the credit union’s 5-year average loss ratio. The examiners will use their judgment to determine whether this is a reasonable ratio to apply to the balance of the loan portfolio in light of current economic conditions and unusually high or low charge-offs in prior periods. Multiply this ratio by total loans outstanding less balances for loans which have been individually classified and reserved for per step (1). For those credit unions which maintain sufficient detail, computing a loss ratio for each loan category (i.e., auto, real estate, member business, etc.) would be appropriate.
- The results of steps (1) and (2) above should be added together and the total compared to the Allowance account balance. The balance should be adjusted if it is materially inaccurate.
Any significant deficiencies in the credit union’s process for determining the level of the Allowance should be clearly detailed in the report of examination. Report comments should emphasize that the credit union’s management is responsible for implementing an effective internal process that will ensure maintenance of an adequate Allowance. The report will also document the agreed upon corrective action necessary to improve the credit union’s process.
ADJUSTMENTS TO THE ALLOWANCE
The examiner’s estimate of an appropriate level for the Allowance should be used to determine whether there has been a significant misstatement of the operating results and the financial condition of the credit union. If the Allowance is determined to be significantly misstated, the examiner should determine whether it has been reviewed by an external auditor performing an audit. If so, the examiner should discuss his or her findings concerning the Allowance with the external auditor to ensure that all available information has been considered.
If, after considering all available information, the examiner concludes that the Allowance has been significantly misstated, credit union management should be requested to make the necessary adjustments to bring the Allowance to an appropriate level.
REGULATORY REPORTING AND ACCOUNTING REQUIREMENTS
The credit union must charge off loan and lease losses in the period when the loans, or portions of loans, are deemed uncollectible and of such little value that their continuance as appropriate assets is not warranted. If the Allowance is determined to be significantly misstated, the credit union must make the necessary adjustments in the quarter the determination is made. If it is clear that significant losses or provisions should have been recognized in a prior period, the Call report for that period must be amended and refiled.
CHANGES IN THE BALANCE OF THE ALLOWANCE
Adjustments to the Allowance resulting from the credit union’s evaluation of its adequacy must be made through charges or credits to the “Provision for loan and lease losses” in the report of income. All charge-offs must be applied directly to the Allowance, and any recoveries on loans or leases previously charged off must be credited to the Allowance. Under no circumstances can loan or lease losses be charged directly to the undivided profits or regular reserve accounts.
The Allowance can never have a debit balance. If losses charged off exceed the amount of the Allowance, a provision sufficient to restore the Allowance to an adequate level must be charged to expenses immediately. A credit union must not increase the Allowance by transfers from the “Undivided profits” accounts or any segregation thereof.
RECOGNITION OF LOSSES IN CONNECTION WITH FORECLOSURES
When a credit union forecloses on a loan or lease, it must recognize a loss equal to the difference between the current fair value of the assets received in the foreclosure or similar settlement and the current carrying value of the loan or lease. That loss must be charged to the Allowance at the time of foreclosure or repossession.
When an asset is sold after being received in a foreclosure or repossession, differences between the estimated loss and the actual loss must be accounted for as follows:
- If the asset is sold soon after foreclosure or repossession (usually not more than 90 days), and the market price for it has not changed while it has been held, the value received in the sale must be substituted for the fair value estimated at the time of foreclosure or repossession and adjustments made to the loss charged against the Allowance.
- If the value has been affected by a change in the market since the foreclosure or repossession, or if the asset is held for more than a short period of time, any additional losses in value or any gains or losses from the sale or disposition of the asset is not a recovery or credit loss and must not be debited or credited to the Allowance. Such additional changes must be reported net on the report of income as “Other noninterest income” or “Other noninterest expense” as appropriate.
When a loan is charged off, any accrued but uncollected interest on the credit union’s books from both current and prior periods should be charged against current earnings. The one exception is when specific provisions have been made to the Allowance for uncollectible accrued interest. In that case, the accrued interest should be charged to the Allowance. For discounted loans, the unearned portion of the loan balance should be charged against the unearned discount account.
CONCLUSION
Every credit union must have a program to establish and regularly review the adequacy of its allowance. The allowance must be maintained at a level that is adequate to cover losses in the loan and lease portfolio that are probable and estimable on the date of the evaluation. This requires management to establish appropriate processes to recognize problem loans in a timely manner and a sound analytical process for estimating the amount of inherent loss in its loan and lease portfolio.
| Thresholds for Classifying Problem Loans | |
| Loan Category | Standard Devaluation |
| All loans greater than 6 months delinquent | 100% of loan balance |
| Loans 4-6 months delinquent – Unsecured | 60% of loan balance |
| Loans 4-6 months delinquent – Secured | 40% of loan balance |
| Loans 2-4 months delinquent – Unsecured | 40% of loan balance |
| Loans 2-4 months delinquent – Secured | 20% of loan balance |
| Loans less than 2 months delinquent | See below |
| Loan Category | Devaluation Percentage |
| Deficiency balance after repossession and sale of collateral | 100% of remaining loan balance |
| Excessive extensions/refinancing of loan resulting in a material understatement of the delinquent status and loss exposure | 100% of variance between collateral value and loan balance |
| Loan to member filing for bankruptcy protection | 100% of variance between collateral value and loan balance |
| Substantial deficit in the loan/value ratio due to the addition of single interest insurance, previous delinquency, decline in the value of the collateral, etc. | 100% of variance between collateral value and loan balance |
| Material documentation deficiencies in home equity loans subject to the penalty provisions included in Section 50, Article XVI of the Texas Constitution | Up to 100% of the loan balance depending on the credit union’s ability to correct the deficiencies
|
| Substandard documentation to support the organization’s continued repayment ability for a member business loan | 10% of the loan balance
|
| Key loan documents missing including the promissory note, security agreement, the credit union’s lien, etc. | Up to 100% of the loan balance based on judgment of the loss exposure |
| Deviations from Threshold |
| Circumstances that will normally warrant a reduction in the devaluation percentage include:
* Strong loan/value ratio * Established repayment plan through the bankruptcy court * Material deposit relationship with the credit union * Acceptable cosigner or other guarantor * Positive repayment performance during the past 90 days
|
| Circumstances that will normally warrant an increase in the devaluation percentage include:
* Member filing for bankruptcy * Poor loan/value ratio * Poor repayment performance during the past 90 days * No payment or contact with the member within 60 days * Substandard documentation for a security interest or lien * Addition of single interest insurance * Member’s loss of employment or other primary means of support |
GLOSSARY OF TERMS
Collateral-dependent – A collateral-dependent loan relies solely on the operation or sale of the collateral for repayment. In evaluating the overall risk associated with a loan, the Department considers a number of factors, including the character, overall financial condition and resources, and payment record of the member; the prospects for support from any financially responsible guarantors; and the nature and degree of protection provided by the cash flow and value of any underlying collateral. However, as other sources of repayment become inadequate over time, the importance of the collateral’s value necessarily increases and the loan may become collateral dependent.
Inherent loss – The Department uses the term inherent loss to mean the amount of loss that meets the conditions of Statement of Financial Accounting Standards (FAS) No. 5 for accrual of loss contingency (i.e., a provision to the allowance). The term is also synonymous with the term “estimated credit losses”.
FAS No. 5 is the primary, authoritative accounting document concerning the accrual of an allowance for loan and lease losses. It defines a “loss contingency” as an existing condition, situation, or set of circumstances involving uncertainty as to possible loss that will ultimately be resolved when one or more future events occur or fail to occur. It might seem that the conditions associated with most loans involve some degree of uncertainty about collectability. However, a provision to the Allowance for loan and lease losses for a loss contingency associated with loans should be made only if both of the following conditions of FAS No. 5 are met:
* Information available as of the evaluation date indicates that it is probable that the value of the loan has been impaired. (One or more future events must be likely to occur and confirm the fact of the loss.) FAS No. 114 clarifies this by stating:
“If, based on current information and events, it is probable that the enterprise will be unable to collect all amounts due according to the contractual terms of the receivable, the condition in [this] paragraph 8(a) is met. As used here, all amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments will be collected as scheduled according to the receivable’s contractual terms. However, a creditor need not consider an insignificant delay or insignificant shortfall in amount of payments as meeting the condition in [this] pa