Late last year, the federal bank regulatory agencies issued an interagency policy statement on allowances for loan an lease Losses. The statement clarifies that it is the "allowance for likely loan and lease losses" rather than an "allowance for possible loan and lease losses," as interpreted by many examiners.

The 1979 joint statement on classification of bank assets and appraisal of securities in bank examinations gained increasing importance and relevance as a result of the recent adoption of the allowance statement.

The statement calls for different methodology and minimum levels of the allowance, depending on whether a loan is classified or not.

Estimated Credit Losses

For classified loans, a bank must provide for all "estimated credit losses" over the remaining effective lives of such loans. However, for loans not classified, only estimated credit losses over the next 12 months must be provided.

Accordingly, consistent application of the new statement requires a bank to properly apply the classification statement, not just in connection with examinations but also in connection with preparation of quarterly call reports.

This analysis is based on the language of the classification and allowance statements, and general principles of interpretation. It may not be consistent with current examiner practice.

Examiners often assign adverse classifications without regard to the language of the classification statement, particularly in regions that recently experienced economic difficulty.

Self-Fulfilling Prophecy

Overclassification of loans often serves as a self-fulfilling prophecy, as it reduces the willingness and ability of bankers in a troubled region to supply the credit necessary to lubricate a local recovery.

The most difficult issue involving classification of loans involves determination of the loans that deserve to be classified substandard. In order to provide for uniformity in classification standards, the federal bank regulatory agencies, along with the Conference of State Bank Supervisors adopted the classification statement.

Loans with more than normal levels of risk, but which fall short of the test for adverse classification, should not be adversely classified, but neither should they be ignored. Such loans require more than normal levels of management attention.

The presence of significant portions of such risky loans may well require increases in the general reserves established by the bank.

'Distinct Possibility' of Loss

The classification statement provides: "Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected."

For a loan to be classified substandard, it must exhibit all of the following characteristics:

1. It must be inadequately protected by the sound worth and paying capacity of the obligor or the collateral pledged.

2. It must have a well-defined weakness or weaknesses.

3. The weaknesses must jeopardize the liquidation of the debt.

4. If the deficiencies are not corrected, there must be a distinct possibility (as opposed to the general possibilities that any borrower may be unwilling or unable to pay his debt, and that collateral values will prove insufficient) that the bank will sustain some loss.

The following examples illustrate the application of these principles:

* The borrower's income does not appear to be sufficient to service the debt fully, but established collateral values show a loan-to-value ratio of 70%. This loan is not adequately protected by the paying capacity of the borrower, but is by the value of the collateral.

The inability of the borrower to service debt from cash flow may jeopardize (make more difficult) the liquidation of the debt, but the collateral value protects the bank against the distinct possibility of loss even if the borrower's income is not enhanced.

In such circumstances, the bank should make all reasonable efforts to continue to monitor the value of the collateral, and to enforce its security interest on a timely basis if there is a default. This loan cannot be classified substandard consistent with the classification statement.

* A borrower with strong cash flow is obligated on a fully amortizing nonrecourse obligation (in California, this might be a purchase money obligation for a home) that exceeds the present value of the collateral.

While it may appear that the loan is adequately protected by the paying capacity of the borrower, the deficient value of the adequately protected by the paying capacity of the borrower, the deficient value of the collateral clearly jeopardizes liquidation of the debt, and presents a distinct possibility that the bank will suffer loss if the deficiency is not corrected.

This loan should be classified substandard. If the obligation were one where recourse to the borrower could be practically enforced, the deficient collateral value may not justify a substandard classification.

Practice Continues

Despite the terms of the classification statement, many examiners and bankers continue to classify a loan substandard if it has unfavorable features that increase risk to collectibility, or that would jeopardize collectibility if combined that other unfavorable contingencies that have not yet occurred, even if it fails to meet the requirements of the classification statement.

The FDIC recognizes that more than normal levels of risk are insufficient to require adverse classification. In its manual of examination policies, with regard to loans that do not meet the classification standards, it states "Other loans of questionable quality, but involving insufficient risk to warrant classification, are designated as special mention loans." The manual later defines "special mention" as follows:

"Included in this category are loans which do not presently expose the bank to a sufficient degree of risk to warrant adverse classification but do possess credit deficiencies deserving management's close attention. failure to correct deficiencies could result in greater credit risk in the future..."

The June 10, 1993, "Inter-agency Statement on the Supervisory Definition of Special Mention Assets," which purports to be one of the President's credit availability initiatives, contains the following definition: "A special mention asset has potential weaknesses that deserve management's close attention.

"If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution's credit position at some future date. Special mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification."

These definitions make it clear that questionable quality, credit deficiencies, and weak origination/servicing policies are insufficient to justify adverse classification of loans that do not at least meet the definition of substandard.

Bankers have the right, and probably the duty, to require examiners to follow the rules set forth in the classification statement and the examination manual, just as regulators expect bankers to follow legal and regulatory standards.

Net Chargeoffs

The core of the allowance statement requires maintenance "at a level that is adequate to absorb estimated credit losses." The statement defines estimated credit losses as estimates of the amounts of loans and leases that are not likely to be collected; that is, net chargeoffs that are likely to be realized..."

While "likely" is not defined in the statement, it means the chance of occurrence is higher than the chance of nonoccurrence. For example, if there is a 49% chance of loss occurring, it is not likely. If there is a 51% chance of loss, it is likely.

Banks may, however, wish to provide for "possible" credit losses which are not yet likely in their financial statements to shareholders.

The statement also mandates that estimated credit losses should be those that meet the criteria for accrual of a loss contingency under generally accepted accounting principles.

When Accrual Is Proper

Under Financial Accounting Standard 5, accrual for a loss contingency is appropriate if: information is available prior to the issuance of the relevant financial statements that indicates that it is probable that the asset has been impaired (and that one or more future events will occur to confirm the fact of the loss), and the amount of the loss can be reasonably estimated.

Thus, if the available information only presents the possibility of a loss, but not the probability, or the amount cannot be reasonably estimated, no loss is accrued. The "probable" requirement of FAS 5 coincides with the "likely" requirement of the statement.

The allowance statement places heightened emphasis on management to: maintain effective systems and controls to identify, monitor and address asset quality problems in a timely manner (this requires an effective loan review and grading system); analyze all significant factors that affect the collectibility of the portfolio; and establish an acceptable evaluation process that meet the objectives of the statement.

The statement supplies considerable guidance for the development and operation of a loan review system, which guidance should be followed.

To the extent that a large portion of the loan portfolio is delinquent or has other unfavorable features, even if not classified adversely, the amount (range) of estimated credit losses for that group of loans should be increased.

However, it is difficult to apply a factor for such increased risk in the case of individually analyzed loans where no loss currently appears probable of occurrence, given the requirements of FAS 5 This produces an anomalous result.

The amounts provided for specifically analyzed loans that are either classified or criticized may be proportionately less, based upon individual analyses of the "likelihood" of loss, than the amounts provided on homogenous pools of loans. This follows since the law of large numbers allows the statistical possibility that some losses will be incurred in the pool to exceed 50%, even though it cannot be said that the possibility of loss on any given loan exceeds 50%.

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