Top insights into the loan loss reserve methodology of banks

Loan loss reserve stands for the contra-asset account on a financial institution’s balance sheet which is netted against gross loans. The loan loss reserve is incremented by the value of loan loss provision in every quarter and decremented by the quantity of net charge-offs. 

Need for loan loss reserve validation

The llr methodology is subjected to review to ascertain its compliance to regulatory guidelines, rationality in determining the reserve allocations and ensure reflection of the same through proper statement in the financial institution’s loan policy.

Determining loan loss reserve

The adjustment of bank’s loan loss reserve is carried out every quarter contingent on the projected interest loss in the institution’s net loan portfolio inclusive of performing and nonperforming ones.

Loan loss reserve methodology may vary from bank to bank, but the loan loss reserve pertaining to lesser balance homogenous loans are typically ascertained by factoring in groups of similar loan types that share similar credit attributes. Various analytical models are embraced which investigates in depth the contributing factors, primarily the projected loss severities, experienced loss frequencies and historical delinquency terms. The reserves for loans take into account the portfolio’s inherent losses which are projected to be discerned in the 12 months to follow. 

The commercial loan reserve is graded based on the probability of repayment, basically on a sixteen point scale. The relationship manager entrusted with the loan disbursement allocates the grade by using the scorecards prepared on basis of loan category and which involves subjective and objective measures. A loan review agency then audits the grades. 

Credits in loan loss reserve validation which emerges with a rating of 1 to 11 are declared ‘pass’, credits with rating 12 are assigned ‘pass watch’, 13 gets ‘special mention’, 14 is ‘substandard’, 15 becomes ‘doubtful’, and 16 is ‘loss’. The total of 13, 14, 15 and 16 are collectively defined as ‘criticized’ loans. Further, loan classification also takes place under the header of FAS 114 impaired loans. Loss reserves are then finally established in consideration of the loan type and grade, migration trends and severity of loss. The experience that took place most recently is assigned most weight. 

A third party reviewer conducts analyzing, testing and validation of the methodology that underlies the general and specific loan allocations. The portfolio experience of the past 3 to 10 years are taken into consideration which involves study of loan grades migration, robustness of the loan grading system, alterations in portfolio mix, and loss experience. Further, portfolio risks trends are also analyzed in consideration of the concentrations like loan and collateral types, large loan exposures, loan policy maintenance, and industry and loan grades. Other factors that are pertinent to the portfolio profile such as off balance sheet commitments, delinquency and non-accrual trends and peers loss experience are also factored in. The observations and conclusions provide valuable insights to fortify the loan loss reserve validation and increase timely loan recovery.

Loan Loss Reserve Methodology and Validation (LLR Methodology) by CEIS Review - http://www.ceisreview.com/pages/Services/2/149/Methodology_Validation