Considerations for Determining the Allowance for Loan and Lease Losses

The Allowance for loan and lease losses (ALLL) has become a popular and controversial topic in banking, particularly since, following the financial crisis, hundreds of institutions suffered losses so great that they contributed to many bank failures.

Banks employ a wide variety of methods for determining the ALLL, ranging from judgmental assumptions to sophisticated statistical and financial models. Given the imprecision inherent in loss estimation methods, a bank should take into account a number of key considerations when attempting to maintain an adequate ALLL. Periodic review of these considerations will help financial institutions develop an ALLL reserve methodology that is conceptually sound and satisfies regulatory expectations.

The process of selecting an appropriate ALLL model methodology can be broadly grouped into five components:

  1. Segmenting the portfolio into more manageable pools of loans.
  2. Determining an appropriate loss-emergence period (LEP).
  3. Determining an appropriate look-back period (LBP).
  4. Designing an appropriate risk-rating framework, if applicable.
  5. Determining an appropriate modeling approach.
The above is based on an excerpt from The RMA Journal, May 2015 article "Considerations for Determining the Allowance for Loan and Lease Losses" by Joseph McPhail, consultant at Ernst & Young LLP and Lihong McPhail, financial economist at the Farm Credit Administration. You can read the article in its entirety here.

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