For a summary of how accounting for loan loss reserves fits into the FASB's and IASB's projects on financial instruments, click here.
Issue
Within the provisions of Generally Accepted Accounting Principles (GAAP) accounting and the asset classification standards of the federal bank regulatory agencies, depository institutions and their holding companies must establish and maintain adequate allowances for loan and lease losses (ALLL).
General Position Statement
The process of establishing an appropriate loan loss reserve involves a significant amount of discretion and expert credit judgment. It must take into account not only a bank's historical experience, but also current economic conditions, and the intimate knowledge a bank has with its customers. ABA supports the process of applying regulatory guidance to loan loss reserves. However, ABA opposes any effort to move toward an accounting approach that restricts bank management's ability to utilize its expertise when determining loan loss reserve levels. As a result of management's judgment, additional reserves may be recorded that are not necessarily identified through empirical analysis.
Underlying the above concepts is that any method to measure loan loss reserves must be operational – the benefits of the process must clearly outweigh the costs of measurement impairment within demanding quarter-end closing timer periods. Second, the results must be conceptually understandable by all stakeholders, including management, regulators, and investors. Finally, the process must be understood to be centered in judgment of different parties (management and real estate appraisers are examples) that is based on a point in time and judgments can change very rapidly.
Upcoming Changes to the Measurement of Loan Loss Reserves
The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have separate proposals on loan loss reserves to measure the amount of reserves required. Both proposals require life of loan “expected loss” estimates, which will require significant operational changes to current bank reserving processes. Processes that use annualized charge-off numbers will not be acceptable. The FASB model requires these estimates for all loans, while the IASB requires the same, but applies a twelve-month probability of default factor to unimpaired loans that have no other signs that indicate “significant credit deterioration”. While the IASB model may result in lower ALLL balances, this model’s operational challenges related to determining probability of defaults and monitoring the signs of “significant credit deterioration” appear to be unmanageable.
ALLL Regulatory Guidance Links