48444, FFIEC's Proposed Policy Statement on Allowance for Loan by omq25257


									54268                     Federal Register / Vol. 65, No. 174 / Thursday, September 7, 2000 / Notices

not-for-profit institutions, and state,                 Buchanan for President, Inc.—                           Examination Council, 2000 K Street,
local or tribal government.                           Statements of Reasons (LRA#512).                          N.W., Suite 310, Washington, DC 20006,
  Number of Respondents: 934.                           Advisory Opinion 2000–20:                               fax number: (202) 872–7501. Comments
  Estimated Time Per Response: 1 hour.                Committee for Quality Cancer Care by                      will be available for public inspection
  Frequency of Response: On occasion                  counsel, Brett G. Kappel.                                 during regular business hours at the
reporting requirement and                               Advisory Opinion 2000–22: Air                           above address. Appointments to inspect
recordkeeping requirement.                            Transportation Association of America,                    comments are encouraged and can be
  Total Annual Burden: 934 hours.                     American Land Title Association,                          arranged by calling the FFIEC at (202)
  Total Annual Cost: N/A.                             Council of Insurance Agents and                           872–7500.
  Needs and Uses: This collection is
                                                      Brokers, Independent Insurance Agents                     FOR FURTHER INFORMATION CONTACT:
necessary to: lessen the administrative
                                                      of America, and the Society of                              FDIC: Carol L. Liquori, Examination
burden of licensees; determine the
                                                      Independent Gasoline Marketers of                         Specialist, Division of Supervision,
partitioned service areas and geographic
                                                      America by counsel, Scott A. Sinder and                   (202) 898–7289, or Doris L. Marsh,
area licensee’s remaining service area of
                                                      Stephen Gold.                                             Examination Specialist, Division of
parties to an agreeement; determine
                                                        Revisions to Reporting Forms and                        Supervision, (202) 898–8905, FDIC, 550
whether geographic area licensee and
                                                      Instructions.                                             17th Street, N.W., Washington, DC
parties to agreements have met the
                                                        Explanation and Justification for                       20429.
applicable coverage requirements for
                                                      Revisions to FEC Reporting Forms.                           FRB: Linda V. Griffith, Supervisory
their service areas; to determine
                                                        Administrative Matters.                                 Financial Analyst, (202) 452–3506, or
whether the applicant is eligible to
receive bidding credit as a small                     PERSON TO CONTACT FOR INFORMATION:                        Arthur Lindo, Supervisory Financial
business; determine the real parties                  Mr. Ron Harris, Press Officer,                            Analyst, (202) 452–2695, Division of
interest in any joint bidding agreements;             Telephone: (202) 694–1220.                                Banking Supervision and Regulation,
and determine the appropriate unjust                                                                            Board of Governors of the Federal
                                                      Mary W. Dove,
enrichment compensation to be remitted                                                                          Reserve System, 20th Street and
                                                      Acting Secretary of the Commission.                       Constitution Avenue, N.W.,
to the government.                                    [FR Doc. 00–23158 Filed 9–5–00; 3:30 pm]                  Washington, DC 20551.
Federal Communications Commission.                    BILLING CODE 6715–01–M                                      OCC: Richard Shack, Senior
Magalie Roman Salas,                                                                                            Accountant, Chief Accountant’s Office,
Secretary.                                                                                                      Core Policy Division, (202) 874–5411, or
[FR Doc. 00–22918 Filed 9–6–00; 8:45 am]              FEDERAL FINANCIAL INSTITUTIONS                            Louise A. Francis, National Bank
BILLING CODE 6712–01–P                                EXAMINATION COUNCIL                                       Examiner, Chief Accountant’s Office,
                                                                                                                Core Policy Division, (202) 874–1306,
                                                      Policy Statement on Allowance for                         Office of the Comptroller of the
FEDERAL ELECTION COMMISSION                           Loan and Lease Losses Methodologies                       Currency, 250 E Street, S.W.,
                                                      and Documentation for Banks and                           Washington, DC 20219.
Sunshine Act Meetings                                 Savings Institutions                                        OTS: William Magrini, Policy
                                                      AGENCY: Federal Financial Institutions                    Analyst, Policy Division, (202) 906–
AGENCY:   Federal Election Commission.
                                                      Examination Council.                                      5744, or Harrison E. Greene, Jr.,
DATE AND TIME:   Tuesday, September 12,                                                                         Securities Accountant, Accounting
2000, 10 a.m.                                         ACTION: Proposed Policy Statement;
                                                                                                                Policy Division, (202) 906–7933, Office
PLACE: 999 E Street, NW., Washington,                 request for comment.                                      of Thrift Supervision, 1700 G Street,
D.C.                                                                                                            N.W., Washington, DC 20552.
                                                      SUMMARY: The Federal Financial
STATUS: This meeting will be closed to
                                                      Institutions Examination Council                          SUPPLEMENTARY INFORMATION:
the public.
                                                      (FFIEC) 1 is requesting comments on a                     I. Background
ITEMS TO BE DISCUSSED:                                proposed Policy Statement on
   Compliance matters pursuant to 2                                                                                On March 10, 1999, the Federal
                                                      Allowance for Loan and Lease Losses
U.S.C. § 437g.                                                                                                  Deposit Insurance Corporation, the
                                                      (ALLL) Methodologies and
   Audits conducted pursuant to 2                                                                               Federal Reserve Board, the Office of the
                                                      Documentation for Banks and Savings
U.S.C. § 437g, § 438(b), and Title 26,                                                                          Comptroller of the Currency, the Office
                                                      Institutions (Policy Statement). This
U.S.C.                                                                                                          of Thrift Supervision, and the Securities
   Matters concerning participation in                proposed Policy Statement is intended
                                                      to provide guidance on the design and                     and Exchange Commission (together,
civil actions or proceedings or                                                                                 the Agencies) issued a joint letter to
arbitration.                                          implementation of ALLL methodologies
                                                      and supporting documentation                              financial institutions on the allowance
   Internal personnel rules and
                                                      practices.                                                for loan and lease losses (the Joint
procedures or matters affecting a
                                                      DATES: Comments must be received by
                                                                                                                Letter). In the Joint Letter, the Agencies
particular employee.
                                                      November 6, 2000.                                         agreed to establish a Joint Working
DATE AND TIME: Thursday, September 14,                                                                          Group to study ALLL issues and to
2000, 10 a.m.                                         ADDRESSES: Comments should be
                                                                                                                assist financial institutions by providing
PLACE: 999 E Street, NW., Washington,                 directed to Keith J. Todd, Executive                      them with improved guidance on this
DC (Ninth Floor).                                     Secretary, Federal Financial Institutions                 topic. The Agencies agreed that the Joint
STATUS: This meeting will be open to the                1 The FFIEC consists of representatives from the
                                                                                                                Working Group would develop and
public.                                               Board of Governors of the Federal Reserve System
                                                                                                                issue parallel guidance for two key areas
ITEMS TO BE DISCUSSED:                                (FRB), the Federal Deposit Insurance Corporation          regarding the ALLL:
   Correction and Approval of Minutes.                (FDIC), the Office of the Comptroller of the                 • Appropriate methodologies and
   Dole for President—Statement of                    Currency (OCC), the Office of Thrift Supervision          supporting documentation, and
                                                      (OTS) (referred to as the ‘‘banking agencies’’), and
Reasons (LRA#467).                                    the National Credit Union Administration.
                                                                                                                   • Enhanced disclosures.
   Dole/Kemp ’96, Inc.—Statement of                   However, this guidance is not directed to credit             This proposed Policy Statement
Reasons (LRA#506).                                    unions.                                                   represents the banking agencies’

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                          Federal Register / Vol. 65, No. 174 / Thursday, September 7, 2000 / Notices                                                     54269

guidance to banks and savings                          appropriate for their size and                          summarize the amount to be reported in
institutions relating to methodologies                 complexity. For smaller institutions                    the financial statements for the ALLL.
and supporting documentation for the                   with fewer and less complex loan                        To verify that the ALLL methodology is
ALLL. The Securities and Exchange                      products, the amount of supporting                      effective and conforms to GAAP and
Commission staff is planning to provide                documentation for the ALLL may be less                  supervisory guidance, a review of the
parallel guidance on this topic for                    exhaustive than for larger institutions.                methodology and its application should
public companies in a future Staff                       Recognizing that a primary mission of                 be completed by external or internal
Accounting Bulletin.2                                  the banking agencies is to support a safe               auditors or some other party unrelated
   This Policy Statement clarifies the                 and sound banking system, examiners                     to the ALLL process, as appropriate for
banking agencies’ expectations                         will continue to evaluate the overall                   the size and complexity of the
regarding methodologies and                            adequacy of the ALLL, including the                     institution.
documentation support for the ALLL                     adequacy of supporting documentation,
                                                                                                                  The proposal includes illustrations of
from a generally accepted accounting                   to ensure that it is appropriate. While
                                                                                                               implementation practices that
principles (GAAP) perspective. For                     the proposed Policy Statement generally
                                                                                                               institutions may find useful for
financial reporting purposes, including                does not provide guidance to examiners
                                                                                                               enhancing their own ALLL practices, an
regulatory reporting, the provision for                in conducting safety and soundness
                                                                                                               appendix that provides examples of
loan and lease losses and the ALLL                     examinations, examiners may criticize
                                                                                                               certain key aspects of ALLL guidance, a
must be determined in accordance with                  institutions that fail to document and
                                                                                                               summary of applicable GAAP guidance,
GAAP and supervisory guidance. GAAP                    maintain an adequate ALLL in
                                                                                                               and a bibliographical list of relevant
requires that an institution maintain                  accordance with this Policy Statement
                                                                                                               GAAP guidance, joint interagency
written documentation to support the                   and other banking agency guidance. In
amounts of the ALLL and the provision                  such cases, institution management may                  statements, and other literature on ALLL
for loan and lease losses reported in the              be cited for engaging in unsafe and                     issues.
financial statements.                                  unsound banking practices and may be                    III. Comments
   The proposal is not intended to                     subject to further supervisory action.
change existing accounting guidance in,                                                                          Comment is requested on all aspects
                                                       II. Principal Elements of the Policy                    of the proposed Policy Statement.
or modify the documentation
requirements of, GAAP or guidance                                                                              IV. Paperwork Reduction Act
provided in the relevant joint                            The proposed Policy Statement
interagency statements issued by the                   clarifies that the board of directors of                  In accordance with the Paperwork
Agencies. It is intended to supplement,                each institution is responsible for                     Reduction Act of 1995 (44 U.S.C.
not replace, the guidance the banking                  ensuring that controls are in place to                  chapter 35), the banking agencies have
agencies provided in their Interagency                 determine the appropriate level of the                  reviewed the proposed Policy Statement
Policy Statement on the Allowance for                  ALLL. It also emphasizes the banking                    and determined that it does not add any
Loan and Lease Losses, which was                       agencies’ long-standing position that                   collections of information pursuant to
issued in December 1993. It is also                    institutions should maintain and                        the Act.
intended to supplement guidance the                    support the ALLL with documentation
                                                       that is consistent with their stated                    V. Proposed Policy Statement
banking agencies provided in their
interagency guidelines establishing                    policies and procedures, GAAP, and                        The text of the proposed Policy
standards for safety and soundness that                applicable supervisory guidance.                        Statement follows:
were issued in 1995 and 1996 pursuant                     The proposed Policy Statement
                                                       provides guidance on significant aspects                Policy Statement on Allowance for Loan and
to Section 39 of the Federal Deposit
                                                       of ALLL methodologies and                               Lease Losses Methodologies and
Insurance Act (FDI Act).3 Under the                                                                            Documentation for Banks and Savings
guidelines for asset quality, each                     documentation practices. Specifically,
                                                       the proposal provides guidance on                       Institutions
institution should estimate and
                                                       maintaining and documenting policies                      Boards of directors of banks and savings
establish a sufficient ALLL supported by                                                                       institutions are responsible for ensuring that
adequate documentation. The proposed                   and procedures that are appropriately
                                                       tailored to the size and complexity of                  their institutions have controls in place to
Policy Statement does not address or                                                                           consistently determine the allowance for loan
change current guidance regarding loan                 the institution and its loan portfolio.                 and lease losses (ALLL) in accordance with
charge-offs; therefore, institutions                   The proposed Policy Statement notes                     the institutions’ stated policies and
should continue to follow existing                     that it is critical for an institution’s                procedures, generally accepted accounting
regulatory guidance that addresses the                 ALLL methodology to incorporate                         principles (GAAP), and ALLL supervisory
timing of charge-offs.                                 management’s current judgments about                    guidance.4 To fulfill this responsibility,
   The guidance in this Policy Statement               the credit quality of the loan portfolio.               boards of directors instruct management to
                                                       The methodology must be a thorough,                     develop and maintain an appropriate,
recognizes that institutions should
                                                       disciplined, and consistently applied                   systematic, and consistently applied process
adopt methodologies and                                                                                        to determine the amounts of the ALLL and
documentation practices that are                       process that is reviewed and approved
                                                                                                               provisions for loan losses. Management
                                                       by the institution’s board of directors.                should create and implement suitable
   2 The American Institute of Certified Public           The proposal also discusses the                      policies and procedures to communicate the
Accountants is developing more specific guidance       methodology and documentation                           ALLL process internally to all applicable
on the accounting for loan losses and the              needed to support ALLL estimates                        personnel. By creating an environment that
techniques for measuring probable incurred loss in     prepared in accordance with GAAP,
a loan portfolio. This guidance is expected to be
                                                                                                               encourages personnel to follow these policies
released in final form in 2001.                        which requires loss estimates based
   3 Institutions should refer to the guidelines       upon reviews of individual loans and                      4 A bibliography is attached that lists applicable

adopted by their primary federal regulator as          groups of loans. After determining the                  ALLL GAAP guidance, interagency policy
follows: For national banks, Appendix A to Part 30;    allowance on individually reviewed                      statements, and other reference materials that may
for state member banks, Appendix D to Part 208;                                                                assist in understanding and implementing an ALLL
for state nonmember banks, Appendix A to Part
                                                       loans and groups of loans, the proposal                 in accordance with GAAP. See Appendix B for
364; for savings associations, Appendix A to Part      states that management should                           additional information on applying GAAP to
570.                                                   consolidate these loss estimates and                    determine the ALLL.

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54270                      Federal Register / Vol. 65, No. 174 / Thursday, September 7, 2000 / Notices

and procedures, management improves                    supervisory guidance is generally an unsafe               (4) ALLL Under FASB Statement of
procedural discipline and compliance.                  and unsound banking practice.                           Financial Accounting Standards No. 5,
  The determination of the amounts of the                This guidance applies equally to all                  Accounting for Contingencies (FAS 5),
ALLL and provisions for loan and lease                 institutions, regardless of the size. Because of          (5) Consolidating the Loss Estimates, and
losses should be based on management’s                 their less complex lending activities and                 (6) Validating the ALLL Methodology.
current judgments about the credit quality of          products, smaller institutions may find it
the loan portfolio, and should consider all                                                                    Policies and Procedures
                                                       more efficient to combine a number of
known relevant internal and external factors           procedures (e.g., information gathering,                   Financial institutions utilize a wide range
that affect loan collectibility as of the              documentation, and internal approval                    of policies, procedures, and control systems
reporting date. The ALLL methodology, the              processes) while continuing to ensure the               in their ALLL process. Sound policies should
associated policies and procedures, and the            institution has a consistent and appropriate            be appropriately tailored to the size and
amounts to be reported each period for the             methodology. Thus, much of the                          complexity of the institution and its loan
provision for loan and lease losses and ALLL           documentation that a larger institution might           portfolio.
should be reviewed and approved by the                 retain in support of the allowance may be                  An institution’s written policies and
board of directors. To ensure the                                                                              procedures for the systems and controls that
                                                       combined into fewer supporting documents
methodology remains appropriate for the                                                                        maintain an appropriate ALLL should
                                                       in a smaller institution. For example,
institution, the board of directors should                                                                     address but not be limited to:
have the methodology periodically validated            simplified documentation can include
                                                       spreadsheets, check lists, and other summary               (1) The roles and responsibilities of the
and, if appropriate, revised. The board of
                                                       documents that many institutions currently              institution’s departments and personnel
directors’ audit committee 5 should oversee
                                                       use. Illustrations A and C provide specific             (including the lending function, credit
and monitor the internal controls over the
ALLL determination process.6                           examples of how smaller institutions may                review, financial reporting, internal audit,
  The banking agencies’ 7 have long-standing           determine and document portions of their                senior management, audit committee, board
examination policies that call for examiners           loan loss allowance.                                    of directors, and others, as applicable) who
to review an institution’s lending and loan                                                                    determine the ALLL to be reported in the
                                                       Documentation Standards                                 financial statements;
review functions and recommend
improvements, if needed. Additionally, in                Appropriate written supporting                           (2) The institution’s accounting policies for
1995 and 1996, the banking agencies adopted            documentation facilitates review of the ALLL            loans and loan losses, including the policies
interagency guidelines establishing standards          process and reported amounts, builds                    for charge-offs and recoveries and for
for safety and soundness, pursuant to Section          discipline into the ALLL determination                  estimating the fair value of collateral, where
39 of the Federal Deposit Insurance Act (FDI           process, and improves the process for                   applicable;
Act).8 The interagency asset quality                   estimating loan and lease losses by helping                (3) The description of the institution’s
guidelines and the guidance in this paper              to ensure that all relevant factors are                 systematic methodology, which should be
assist an institution in estimating and                appropriately considered in the ALLL                    consistent with the institution’s accounting
establishing a sufficient ALLL supported by            analysis. An institution should document the            policies for determining its ALLL; 10 and
adequate documentation, as required under              relationship between the findings of its                   (4) The system of internal controls used to
the FDI Act. Additionally, the guidelines              detailed review of the loan portfolio and the           ensure that the ALLL process is maintained
require operational and managerial standards           amount of the ALLL and the provision for                in accordance with GAAP and supervisory
that are appropriate for an institution’s size         loan and lease losses reported in each                  guidance.
and the nature and scope of its activities.            period.9                                                   An internal control system for the ALLL
  For financial reporting purposes, including            At a minimum, institutions should                     estimation process should:
regulatory reporting, the provision for loan           maintain written supporting documentation                  (1) Include measures to ensure the
and lease losses and the ALLL must be                  for the following decisions, strategies, and            reliability and integrity of information and
determined in accordance with GAAP. GAAP               processes:                                              compliance with laws, regulations, and
requires that allowances be well                         (1) Policies and procedures:                          internal policies and procedures;
documented, with clear explanations of the               (a) Over the systems and controls that                   (2) Ensure that the institution’s financial
supporting analyses and rationale. This                maintain an appropriate ALLL and                        statements (including regulatory reports) are
Policy Statement describes but does not                  (b) Over the ALLL methodology,                        prepared in accordance with GAAP and
increase the documentation requirements                  (2) Loan grading system or process,                   ALLL supervisory guidance; 11 and
already existing within GAAP. Failure to                 (3) Summary or ‘‘roll-up’’ of the ALLL                   (3) Include a well-defined loan review
maintain, analyze, or support an adequate              balance,                                                process containing:
ALLL in accordance with GAAP and                         (4) Validation of the ALLL methodology,                  (a) An effective loan grading system that is
                                                       and                                                     consistently applied, identifies differing risk
   5 While all institutions are encouraged to
                                                         (5) Justification for periodic adjustments to         characteristics and loan quality problems
establish audit committees, small institutions         the ALLL process.                                       accurately and in a timely manner, and
without audit committees should have the board of        The following sections of this Policy                 prompts appropriate administrative actions;
directors assume this responsibility.
   6 Institutions and their auditors should refer to
                                                       Statement provide guidance on significant                  (b) Sufficient internal controls to ensure
Statement on Auditing Standards No. 61,
                                                       aspects of ALLL methodologies and                       that all relevant loan review information is
Communication With Audit Committees (as                documentation practices. Specifically, the
amended by Statement on Auditing Standards No.         paper provides guidance on:                               10 Further explanation is presented in the
90, Audit Committee Communications), which               (1) Policies and Procedures,                          Methodology section that appears below.
requires certain discussions between the auditor         (2) Methodology,                                        11 11 In addition to the supporting documentation
and the audit committee. These discussions should        (3) ALLL Under Financial Accounting                   requirements for financial institutions, as described
include items, such as accounting policies and         Standards Board (FASB) Statement of                     in interagency asset quality guidelines, public
estimates, judgments, and uncertainties, that have     Financial Accounting Standards No. 114,                 companies are required to comply with the books
a significant impact on the accounting information                                                             and records provisions of the Securities Exchange
included in the financial statements.
                                                       Accounting by Creditors for Impairment of a
                                                       Loan (FAS 114),                                         Act of 1934 (Exchange Act). Under Sections
   7 The banking agencies are the Federal Deposit
                                                                                                               13(b)(2)–(7) of the Exchange Act, registrants must
Insurance Corporation, the Federal Reserve Board,                                                              make and keep books, records, and accounts,
the Office of the Comptroller of the Currency, and       9 This position is fully described for public         which, in reasonable detail, accurately and fairly
the Office of Thrift Supervision.                      companies in the Securities and Exchange                reflect the transactions and dispositions of assets of
   8 Institutions should refer to the guidelines       Commission’s (SEC) Financial Reporting Release          the registrant. Registrants also must maintain
adopted by their primary federal regulator as          No. 28 (FRR 28), in which the SEC indicates that        internal accounting controls that are sufficient to
follows: For national banks, Appendix A to Part 30;    the books and records of public companies engaged       provide reasonable assurances that, among other
for state member banks, Appendix D to Part 208;        in lending activities should include documentation      things, transactions are recorded as necessary to
for state nonmember banks, Appendix A to Part          of the rationale supporting each period’s               permit the preparation of financial statements in
364; for savings associations, Appendix A to Part      determination that the ALLL and provision               conformity with GAAP. See also SEC Staff
570.                                                   amounts reported were adequate.                         Accounting Bulletin No. 99, Materiality.

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                          Federal Register / Vol. 65, No. 174 / Thursday, September 7, 2000 / Notices                                                    54271

appropriately considered in estimating                 grouped with other loans that share common              #2 in Appendix A provide examples of
losses. This includes maintaining appropriate          characteristics for impairment evaluation               applying and documenting impairment
reports, details of reviews performed, and             under FAS 5.                                            measurement methods under FAS 114.
identification of personnel involved; and                 (3) For determining and measuring                      Begin Text Box—Illustration A
  (c) Clear formal communication and                   impairment by applying loss rates to loan               (Documenting an ALLL Under FAS 114,
coordination between an institution’s credit           balances under FAS 5:                                   Comprehensive worksheet for the impairment
administration function, financial reporting              (a) How loans with similar characteristics           measurement process): A small institution
group, management, board of directors, and             are grouped to be evaluated for loan                    utilizes a comprehensive worksheet for each
others who are involved in the ALLL                    collectibility (such as loan type, past-due             loan being reviewed individually under FAS
determination process (e.g., written policies          status, and risk);                                      114. Each worksheet includes a description
and procedures, management reports, audit                 (b) How historical loss rates are determined         of why the loan was selected for individual
programs, and committee minutes).                      and what factors are considered when                    review, the impairment measurement
                                                       establishing appropriate time frames over               technique used, the measurement
                                                       which to evaluate loss experience; and                  calculation, a comparison to the current loan
   An ALLL methodology is a system that an                (c) Descriptions of qualitative factors (e.g.,       balance, and the amount of the ALLL for that
institution designs and implements to                  changes in economic conditions) that may                loan. The rationale for the impairment
reasonably estimate loan and lease losses as           affect loss rates or other loss measurements.           measurement technique used (e.g., present
of the financial statement date. It is critical           The supporting documents for the ALLL                value of expected future cash flows,
that ALLL methodologies incorporate                    may be integrated in an institution’s credit            observable market price of the loan, fair
management’s current judgments about the               files, loan review reports or worksheets,               value of the collateral) is also described on
credit quality of the loan portfolio through a         board of directors’ and committee meeting               the worksheet. End Text Box
disciplined and consistently applied process.          minutes, computer reports, or other                       Some loans that are evaluated individually
   An institution’s ALLL methodology is                appropriate documents and files.                        for impairment under FAS 114 may be fully
influenced by institution-specific factors,                                                                    collateralized and therefore require no ALLL.
such as an institution’s size, organizational          ALLL Under FAS 114                                      Q&A #3 in Appendix A presents an example
structure, business environment and strategy,             An institution’s ALLL methodology related            of an institution whose loan portfolio
management style, loan portfolio                       to FAS 114 loans begins with the use of its             includes fully collateralized loans and
characteristics, loan administration                   normal loan review procedures to identify               describes the documentation maintained to
procedures, and management information                 whether a loan is impaired as defined by the            support the conclusion that no ALLL was
systems. However, there are certain common             accounting standard. Institutions should                needed for those loans.
elements an institution should incorporate in          document:
its ALLL methodology. A summary of                        (1) The method and process for identifying           ALLL Under FAS 5
common elements is provided in Appendix                loans to be evaluated under FAS 114 and                 Segmenting the Portfolio
B.12                                                      (2) The analysis that resulted in an
                                                                                                                  For loans evaluated on a group basis under
Documentation of ALLL Methodology in                   impairment decision for each loan and the
                                                                                                               FAS 5, management should segment the loan
Written Policies and Procedures                        determination of the impairment
                                                                                                               portfolio by identifying risk characteristics
                                                       measurement method to be used (i.e., present
   An institution’s formal policies and                                                                        that are common to groups of loans.
                                                       value of expected future cash flows, fair
procedures should describe the primary                                                                         Institutions decide how to segment their loan
                                                       value of collateral less costs to sell, or the
elements of the institution’s ALLL                                                                             portfolios based on many factors, which vary
                                                       loan’s observable market price).
methodology. Such elements would include                                                                       with their business strategies as well as their
                                                          Once an institution has determined which
portfolio segmentation, impairment                                                                             information system capabilities. Smaller
                                                       of the three available measurement methods
measurement, and loss rate determination.                                                                      institutions that are involved in less complex
                                                       to use for an impaired loan under FAS 114,
Specifically, written policies and procedures                                                                  activities often segment the portfolio into
                                                       it should maintain supporting documentation
should describe the methodology:                                                                               broad loan categories. This method of
                                                       as follows:
   (1) For segmenting the portfolio:                                                                           segmenting the portfolio is likely to be
   (a) How the segmentation process is                    (1) When using the present value of
                                                                                                               appropriate in only the smallest of
performed (i.e., by loan type, industry, risk          expected future cash flows method:
                                                                                                               institutions offering a narrow range of loan
rates, etc.),                                             (a) The amount and timing of cash flows,
                                                                                                               products. Larger institutions typically offer a
   (b) When a loan grading system is used to              (b) The effective interest rate used to
                                                                                                               more diverse and complex mix of loan
segment the portfolio:                                 discount the cash flows, and
                                                                                                               products. Such institutions may start by
   (i) The definitions of each loan grade,                (c) The basis for the determination of cash
                                                                                                               segmenting the portfolio into major loan
   (ii) A reconciliation of the internal loan          flows, including consideration of current
                                                                                                               types but typically have more detailed
grades to supervisory loan grades, and                 environmental factors and other information
                                                                                                               information available that allows them to
   (iii) The delineation of responsibilities for       reflecting past events and current conditions.
                                                                                                               further segregate the portfolio into product
the loan grading system.                                  (2) When using the fair value of collateral
                                                                                                               line segments based on the risk
   (2) For determining and measuring                   method:
                                                                                                               characteristics of each portfolio segment.
impairment under FAS 114:                                 (a) How fair value was determined,
                                                                                                               Regardless of the method used,
   (a) The methods used to identify loans to           including the use of appraisals, valuation
                                                                                                               documentation should be maintained to
be analyzed individually;                              assumptions, and calculations,
                                                                                                               support that the loans in each segment have
   (b) For individually reviewed loans that are           (b) The supporting rationale for
                                                                                                               similar attributes or characteristics.
impaired, how the amount of any impairment             adjustments to appraised values, if any,
                                                                                                                  As economic and other business conditions
is determined and measured, including:                    (c) The determination of costs to sell, if
                                                                                                               change, institutions often modify their
   (i) Procedures describing the impairment            applicable, and
                                                                                                               business strategies, which may result in
measurement techniques available and                      (d) Appraisal quality and expertise of the
                                                                                                               adjustments to the way in which they
   (ii) Steps performed to determine which             appraiser.
                                                                                                               segment their loan portfolio for purposes of
technique is most appropriate in a given                  (3) When using the observable market price
                                                                                                               estimating loan losses. Illustration B presents
situation.                                             of a loan method:
                                                                                                               an example in which an institution refined
   (c) The methods used to determine                      (a) The amount, source, and date of the
                                                                                                               its segmentation method to more effectively
whether and how loans individually                     observable market price.
evaluated under FAS 114, but not considered               Illustration A describes a practice used by
                                                       a small financial institution to document its           implement the guidance provided in this document.
to be individually impaired, should be                                                                         The methods described in the illustrations may not
                                                       FAS 114 measurement of impairment using                 be suitable for all institutions and are not
  12 Also, refer to paragraph 7.05 of the American     a comprehensive worksheet.13 Q&A #1 and                 considered required processes or actions. For
Institute of Certified Public Accountants’ (AICPA)                                                             additional descriptions of key aspects of ALLL
Audit and Accounting Guide, Banks and Savings            13 The referenced ‘‘gray box’’ illustrations are      guidance, a series of ALLL Questions and Answers
Institutions, 1999 edition (AICPA Audit Guide).        presented to assist institutions in evaluating how to   (Q&As) are included in Appendix A of this paper.

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54272                     Federal Register / Vol. 65, No. 174 / Thursday, September 7, 2000 / Notices

consider risk factors and maintains                    loss rates to the groups’ aggregate loan                    To adjust historical loss rates for current
documentation to support this change.                  balances. Such loss rates typically reflect               conditions, institutions should consider
  Begin Text Box—Illustration B                        historical loan loss experience for each group            environmental factors and then document
(Documenting Segmenting Practices,                     of loans, adjusted for relevant environmental             which factors were used in the analysis.
Documenting a refinement in a segmentation             factors (e.g., industry, geographical,                    Factors that should be considered in
method): An institution with a significant             economic, and political factors) over a                   adjusting historical loss rates include the
portfolio of consumer loans performed a                defined period of time. If an institution does            following: 17
review of its ALLL methodology. The                    not have loss experience of its own, it may                 (1) Levels of and trends in delinquencies
institution had determined its ALLL based              be appropriate to reference the loss                      and impaired loans;
upon historical loss rates in the overall              experience of other institutions, provided                  (2) Levels of and trends in charge-offs and
consumer portfolio. The ALLL methodology               that the institution demonstrates that the                recoveries;
was validated by comparing actual loss rates           attributes of the loans in its portfolio segment            (3) Trends in volume and terms of loans;
(charge-offs) for the past two years to the            are similar to those of the loans included in               (4) Effects of any changes in risk selection
estimated loss rates. During this process, the         the portfolio of the institution providing the            and underwriting standards, and other
institution decided to evaluate loss rates on          loss experience.16 Institutions should                    changes in lending policies, procedures, and
an individual product basis (e.g., auto loans,         maintain supporting documentation for the                 practices;
unsecured loans, or home equity loans). This           technique used to develop their loss rates,                 (5) Experience, ability, and depth of
analysis disclosed significant differences in          including the period of time over which the               lending management and other relevant staff;
the loss rates on different products. With this        losses were incurred. Institutions that                     (6) National and local economic trends and
additional information, the methodology was            determine losses based upon a range of loss               conditions, and industry conditions; and
amended in the current period to segment the           should maintain documentation to support                    (7) Effects of changes in credit
portfolio by product, resulting in a better            the identified range of loss and the rationale            concentrations.
estimation of the loan losses associated with          used for determining which estimate is the                  For any adjustment of historical loss rates,
the portfolio. To support this change in               best estimate within the range of loan losses.            the institution should document that the
segmentation practice, the credit review               An example of how a small institution                     adjustment is necessary to reflect current
committee records contain the analysis that            performs a comprehensive historical loss                  information, events, circumstances, and
was used as a basis for the change and the             analysis is provided as the first item in                 conditions in the loss rates. The second item
written report describing the need for the             Illustration C.                                           in Illustration C provides an example of how
change. End Text Box                                      Begin Text Box—Illustration C                          an institution adjusts its commercial real
  Institutions use a variety of documents to           (Documenting Setting Loss Rates, First                    estate historical loss rates for changes in local
support the segmentation of their portfolios.          Illustration, Comprehensive historical loss               economic conditions. Q&A #4 in Appendix A
Some of these documents include:                       analysis in a small institution): A small                 provides an example of maintaining
  (1) Loan trial balances by categories and            institution determines its historical loss rates          supporting documentation for adjustments to
types of loans,                                        based on annual loss rates over a three-year              portfolio segment loss rates for an
  (2) Management reports about the mix of              historical period. The analysis is conducted              environmental factor related to an economic
loans in the portfolio,                                by type of loan and is further segmented by               downturn in the borrower’s primary
  (3) Delinquency and nonaccrual reports,              originating branch office. The analysis                   industry. Q&A #5 in Appendix A describes
and                                                    considers charge-offs and recoveries in                   one institution’s process for determining and
  (4) A summary presentation of the results                                                                      documenting an ALLL for loans that are not
                                                       determining the loss rate. The institution also
of an internal or external loan grading                                                                          individually impaired but have
                                                       considers the loss rates for each loan grade
review.                                                                                                          characteristics indicating there are loan
                                                       and compares them to historical losses on
  Reports generated to assess the profitability
                                                       similarly rated loans in arriving at the                  losses on a group basis.
of a loan product line may be useful in
identifying areas in which to further segment          historical loss factor. The institution
                                                                                                                 Consolidating the Loss Estimates
the portfolio.                                         maintains supporting documentation for its
                                                       loss factor analysis, including historical                   To verify that ALLL balances are presented
Estimating Loss on Groups of Loans                     losses by type of loan, originating branch                fairly in accordance with GAAP and are
                                                       office, and loan grade for the three-year                 auditable, management should prepare a
  Based on the segmentation of the portfolio,
                                                       period.                                                   document that summarizes the amount to be
an institution estimates the loan and lease
                                                          (Second Illustration, Adjustment of                    reported in the financial statements for the
losses to determine the appropriate level of
                                                       historical rates for changes in local economic            ALLL. The board of directors should review
the FAS 5 portion of the ALLL.14 For those
segments that require an ALLL, the                     conditions): An institution develops a factor             and approve this summary.
institution estimates the loan and lease               to adjust historical loss rates for its                      Common elements in such summaries
losses, on at least a quarterly basis, based           assessment of the impact of changes in the                include:
upon its ongoing loan review process and               local economy. For example, when analyzing                   (1) An estimate of the probable loss or
analysis of loan performance. The institution          the loss rate on commercial real estate loans,            range of loss incurred for each category
should follow a systematic and consistently            the assessment identifies changes in recent               evaluated (e.g., individually evaluated
applied approach to select the most                    commercial building occupancy rates. The                  impaired loans, homogeneous pools, and
appropriate loss measurement methods and               institution generally finds the occupancy                 other groups of loans that are collectively
support its conclusions and rationale with             statistics to be a good indicator of probable             evaluated for impairment);
written documentation. Regardless of the               losses on these types of loans. The institution              (2) The aggregate probable loss estimated
method used to determine loss rates, an                maintains documentation that summarizes                   using the institution’s methodology;
institution should demonstrate and                     the relationship between current occupancy                   (3) A summary of the current ALLL
document that the loss rates used to estimate          rates and its loss experience. End Text Box               balance;
the ALLL for each segment are determined in               Before employing a loss estimation model,                 (4) The amount, if any, by which the ALLL
accordance with GAAP as of the financial               an institution should evaluate and modify, as             is to be adjusted; 18 and
statement date.15                                      needed, the model’s assumptions to ensure                    (5) Depending on the level of detail that
  One method of estimating loan losses for                                                                       supports the ALLL analysis, detailed
                                                       that the resulting loss estimate is consistent
groups of loans is through the application of                                                                    subschedules of loss estimates that reconcile
                                                       with GAAP. Institutions that use loss
                                                                                                                 to the summary schedule.
                                                       estimation models typically document the
  14 An example of a loan segment that does not
                                                       evaluation, the conclusions regarding the
                                                                                                                   17 Refer to paragraph 7.13 in the AICPA Audit
generally require an ALLL includes loans that are      appropriateness of estimating loan losses
fully secured by deposits maintained at the lending                                                              Guide.
                                                       with a model or other loss estimation tool,
institution.                                                                                                       18 Subsequent to adjustments, there should be no
                                                       and the support for adjustments to the model
  15 Refer to paragraph 8(b) of FAS 5. Also, the                                                                 material differences between the consolidated loss
AICPA is currently developing a Statement of
                                                       or its results.                                           estimate, as determined by the methodology, and
Position that will provide more specific guidance                                                                the final ALLL balance reported in the financial
on accounting for loan losses.                            16 Refer   to paragraph 23 of FAS 5.                   statements.

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   Illustration D describes how institutions            (3) A review by an independent party, such            discount the cash flows, and the basis for the
may document their estimated ALLL by                  as an independent loan review committee,                determination of cash flows, including
adding comprehensive explanations to their            external auditors, or internal audit staff. This        consideration of current environmental
summary schedules.                                    often involves the independent party                    factors and other information reflecting past
   Begin Text Box—Illustration D                      reviewing, on a test basis, source documents            events and current conditions. When using
(Consolidating Estimates, Descriptive                 and underlying assumptions to determine                 the fair value of collateral to measure
comments added to the consolidated ALLL               that the established methodology develops               impairment, Institution A should document
summary schedule): To simplify the                    reasonable loss estimates.                              how it determined the fair value, including
supporting documentation process and to                 (4) An evaluation of the appraisal process            the use of appraisals, valuation assumptions
eliminate redundancy, some institutions               of the underlying collateral. This may be               and calculations, the supporting rationale for
include detailed supporting information on            accomplished by periodically comparing the              adjustments to appraised values, if any, and
their summary schedules. For example, in              appraised value to the actual sales price on            the determination of costs to sell, if
the summary schedule that presents FAS 114            selected properties sold.                               applicable. Similarly, Institution A should
allowances, some institutions describe their                                                                  document the amount, source, and date of
policy for selecting loans for evaluation             Supporting Documentation for the Validation
                                                                                                              the observable market price of a loan, if that
under FAS 114. Institutions identify which            Process
                                                                                                              method of measuring loan impairment is
FAS 114 impairment measurement method                    Management usually supports the                      used.
was used for each individually reviewed               validation process with the workpapers from
impaired loan. Other items include brief              the review of the ALLL function. Additional             Q&A #2—ALLL Under FAS 114—Measuring
descriptions of loss factors for particular           documentation often includes the summary                Impairment for a Collateral Dependent Loan
segments of the loan portfolio, the basis for         findings of the independent third party                    Facts: Institution B has a $10 million loan
adjustments to loss rates, and explanations           reviewer. The institution’s board of directors,         outstanding to Company X that is secured by
of changes in ALLL amounts from period to             or its designee, reviews the findings and               real estate, which Institution B individually
period. End Text Box                                  acknowledges its review in its meeting                  evaluates under FAS 114 due to the loan’s
   Generally, an institution’s review and             minutes. If the methodology is changed based            size. Company X is delinquent in its loan
approval process for the ALLL relies upon             upon the findings of the validation process,            payments under the terms of the loan
the data provided in these consolidated               documentation that describes and supports               agreement. Accordingly, Institution B
summaries. There may be instances in which            the changes should be maintained.                       determines that its loan to Company X is
individuals or committees that review the                                                                     impaired, as defined by FAS 114. Because
ALLL methodology and resulting allowance              Appendix A.—ALLL Questions and
                                                                                                              the loan is collateral dependent, Institution B
balance identify adjustments that need to be          Answers                                                 measures impairment of the loan based on
made to the loss estimates to provide a better                                                                the fair value of the collateral. Institution B
                                                      Q&A #1—ALLL Under FAS 114—Measuring
estimate of loan losses. These changes may                                                                    determines that the most recent valuation of
be due to information not known at the time           and Documenting Impairment
                                                                                                              the collateral was performed by an appraiser
of the initial loss estimate (e.g., information          Facts: Approximately one-third of
                                                                                                              eighteen months ago and, at that time, the
that surfaces after determining and adjusting,        Institution A’s commercial loan portfolio
                                                                                                              estimated value of the collateral (fair value
as necessary, historical loss rates, or a recent      consists of large balance, non-homogeneous
                                                      loans. Due to their large individual balances,          less costs to sell) was $12 million.
decline in the marketability of property after
                                                      these loans meet the criteria under Institution            Institution B believes that many of the
conducting a FAS 114 valuation based upon
                                                      A’s policies and procedures for individual              assumptions that were used to value the
the fair value of collateral). It is important
                                                      review for impairment under FAS 114. Upon               collateral eighteen months ago do not reflect
that these adjustments are consistent with
                                                      review of the large balance loans, Institution          current market conditions and, therefore, the
GAAP and are reviewed and approved by
                                                      A determines that certain of the loans are              appraiser’s valuation does not approximate
appropriate personnel. Additionally, the
                                                      impaired as defined by FAS 114.                         current fair value of the collateral. Several
summary should provide each subsequent
                                                         Question: For the commercial loans                   buildings, which are comparable to the real
reviewer with an understanding of the
support behind these adjustments. Therefore,          reviewed under FAS 114 that are                         estate collateral, were recently completed in
management should document the nature of              individually impaired, how should                       the area, increasing vacancy rates, decreasing
any adjustments and the underlying rationale          Institution A measure and document the                  lease rates, and attracting several tenants
for making the changes. This documentation            impairment on those loans? Can it use an                away from the borrower. Accordingly, credit
should be provided to those making the final          impairment measurement method other than                review personnel at Institution B adjust
determination of the ALLL amount. Q&A #6              the methods allowed by FAS 114?                         certain of the valuation assumptions to better
in Appendix A addresses the documentation                Interpretive Response: For those loans that          reflect the current market conditions as they
of the final amount of the ALLL.                      are reviewed individually under FAS 114                 relate to the loan’s collateral. After adjusting
                                                      and considered individually impaired,                   the collateral valuation assumptions, the
Validating the ALLL Methodology                       Institution A must use one of the methods for           credit review department determines that the
   To verify that the ALLL methodology is             measuring impairment that is specified by               current estimated fair value of the collateral,
effective and conforms to GAAP and                    FAS 114 (that is, the present value of                  less costs to sell, is $8 million. Given that the
supervisory guidance, an institution’s                expected future cash flows, the loan’s                  recorded investment in the loan is $10
directors should establish internal control           observable market price, or the fair value of           million, Institution B concludes that the loan
procedures, appropriate for the size and              collateral). Accordingly, in the circumstances          is impaired by $2 million and records an
complexity of the institution. These                  described above, for the loans considered               allowance for loan losses of $2 million.
procedures should include an independent              individually impaired under FAS 114, it                    Question: What type of documentation
review of the methodology and its                     would not be appropriate for Institution A to           should Institution B maintain to support its
application.                                          choose a measurement method not                         determination of the allowance for loan
   In practice, financial institutions employ         prescribed by FAS 114. For example, it                  losses of $2 million for the loan to Company
numerous procedures when validating the               would not be appropriate to measure loan                X?
reasonableness of their ALLL methodology              impairment by applying a loss rate to each                 Interpretive Response: Institution B should
and determining whether there may be                  loan based on the average historical loss               document that it measured impairment of the
deficiencies in their overall methodology or          percentage for all of its commercial loans for          loan to Company X by using the fair value
loan grading process. Examples are:                   the past five years.                                    of the loan’s collateral, less costs to sell,
   (1) A review of trends in loan volume,                Institution A should maintain written                which it estimated to be $8 million. This
delinquencies, restructurings, and                    documentation to support its measurement of             documentation should include the
concentrations.                                       loan impairment under FAS 114. If it uses               institution’s rationale and basis for the $8
   (2) A review of previous charge-off and            the present value of expected future cash               million valuation, including the revised
recovery history, including an evaluation of          flows to measure impairment of a loan, it               valuation assumptions it used, the valuation
the timeliness of the entries to record both          should document the amount and timing of                calculation, and the determination of costs to
the charge-offs and the recoveries.                   cash flows, the effective interest rate used to         sell, if applicable. Because Institution B

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54274                      Federal Register / Vol. 65, No. 174 / Thursday, September 7, 2000 / Notices

arrived at the valuation of $8 million by                  (2) Recency and reliability of the appraisal         how the current situation compares to the
modifying an earlier appraisal, it should               or other valuation                                      institution’s previous loss experiences in
document its rationale and basis for the                   (3) Recency of the bank or other third party         similar circumstances. A summary of the
changes it made to the valuation assumptions            inspection of the collateral                            amount and rationale for the adjustment
that resulted in the collateral value declining            (4) Historical losses on similar loans               factor is presented to the audit committee
from $12 million eighteen months ago to $8                 (5) Confidence in the bank’s lien or                 and board for their review and approval prior
million in the current period.19                        security position including appropriate:                to the issuance of the financial statements.
                                                           (a) Type of security perfection (e.g.,
Q&A #3—ALLL Under FAS 114—Fully                                                                                 Q&A #5—ALLL Under FAS 5—Estimating
                                                        physical possession of collateral or secured
Collateralized Loans                                                                                            Losses on Loans Individually Reviewed for
   Facts: Institution C has $10 million in                                                                      Impairment but Not Considered Individually
                                                           (b) Filing of security perfection (i.e., correct
loans that are fully collateralized by highly                                                                   Impaired
                                                        documents and with the appropriate
rated debt securities with readily                      officials), and                                            Facts: Institution E has outstanding loans
determinable market values. The loan                       (c) Relationship to other liens.                     of $2 million to Company Y and $1 million
agreement for each of these loans requires the                                                                  to Company Z, both of which are paying as
borrower to provide qualifying collateral               Q&A #4—ALLL Under FAS 5—Adjusting                       agreed upon in the loan documents. The
sufficient to maintain a loan-to-value ratio            Loss Rates                                              institution’s ALLL policy specifies that all
with sufficient margin to absorb volatility in             Facts: Institution D’s lending area includes         loans greater than $750,000 must be
the securities’ market prices. Institution C’s          a metropolitan area that is financially                 individually reviewed for impairment under
collateral department has physical control of           dependent upon the profitability of a number            FAS 114. Company Y’s financial statements
the debt securities through safekeeping                 of manufacturing businesses. These                      reflect a strong net worth, good profits, and
arrangements. In addition, Institution C                businesses use highly specialized equipment             ongoing ability to meet debt service
perfected its security interest in the collateral       and significant quantities of rare metals in            requirements. In contrast, recent information
when the funds were originally distributed.             the manufacturing process. Due to increased             indicates Company Z’s profitability is
On a quarterly basis, Institution C’s credit            low-cost foreign competition, several of the            declining and its cash flow is tight.
administration function determines the                  parts suppliers servicing these manufacturing           Accordingly, this loan is rated substandard
market value of the collateral for each loan            firms declared bankruptcy. The foreign                  under the institution’s loan grading system.
using two independent market quotes and                 suppliers have subsequently increased prices            Despite its concern, management believes
compares the collateral value to the loan               and the manufacturing firms have suffered               Company Z will resolve its problems and
carrying value. If there are any collateral             from increased equipment maintenance costs              determines that neither loan is individually
deficiencies, Institution C notifies the                and smaller profit margins. Additionally, the           impaired as defined by FAS 114.
borrower and requests that the borrower                 cost of the rare metals used in the                        Institution E segments its loan portfolio to
immediately remedy the deficiency. Due in               manufacturing process increased and has                 estimate loan losses under FAS 5. Two of its
part to its efficient operation, Institution C          now stabilized at double last year’s price.             loan portfolio segments are Segment 1 and
has historically not incurred any material              Due to these events, the manufacturing                  Segment 2. The loan to Company Y has risk
losses on these loans. Institution C believes           businesses are experiencing financial                   characteristics similar to the loans included
these loans are fully-collateralized and                difficulties and have recently announced                in Segment 1 and the loan to Company Z has
therefore does not maintain any ALLL                                                                            risk characteristics similar to the loans
                                                        downsizing plans.
balance for these loans.                                                                                        included in Segment 2.20
                                                           Although Institution D has yet to confirm
   Question: What documentation does                                                                               Question: How does Institution E
                                                        an increase in its loss experience as a result
Institution C maintain to adequately support                                                                    adequately support and document an ALLL
                                                        of these events, management knows that the
its determination that no allowance is needed                                                                   under FAS 5 for these loans that were
                                                        institution lends to a significant number of
for this group of loans?                                                                                        individually reviewed for impairment but are
                                                        businesses and individuals whose repayment
   Interpretive Response: Institution C’s                                                                       not considered individually impaired?
                                                        ability depends upon the long-term viability
management summary of the ALLL includes                                                                            Interpretive Response: In its determination
                                                        of the manufacturing businesses. Institution
documentation indicating that, in accordance                                                                    of the ALLL under FAS 5, Institution E
                                                        D’s management has identified particular
with the institution’s ALLL policy, the                                                                         includes its loans to Company Y and
                                                        segments of its commercial and consumer                 Company Z in the groups of loans with
collateral protection on these loans has been           customer bases that include borrowers highly
verified by the institution, no probable loss                                                                   similar characteristics (i.e., Segment 1 for
                                                        dependent upon sales or salary from the                 Company Y’s loan and Segment 2 for
has been incurred, and no ALLL is necessary.            manufacturing businesses. Institution D’s
Documentation in Institution C’s loan files                                                                     Company Z’s loan). Management’s analyses
                                                        management performs an analysis of the                  of Segment 1 and Segment 2 indicates that
includes the two independent market quotes              affected portfolio segments to adjust its               it is probable that each segment includes
obtained each quarter for each loan’s                   historical loss rates used to determine the             some losses, even though the losses cannot
collateral amount, the documents evidencing             ALLL.                                                   be identified to one or more specific loans.
the perfection of the security interest in the             Question: How should Institution D                   Management estimates that the use of its
collateral, and other relevant supporting               document its support for the loss rate                  historical loss rates for these two segments,
documents. Additionally, Institution C’s                adjustments that result from considering                with adjustments for changes in
ALLL policy includes a discussion of how to             these manufacturing firms’ financial                    environmental factors, such as current local
determine when a loan is considered ‘‘fully             downturns?                                              economic conditions, provides a reasonable
collateralized’’ and does not require an                   Interpretive Response: Institution D should          estimate of the institution’s probable loan
ALLL. The policy requires the following                 document its identification of the particular           losses in these segments.
factors, at a minimum, to be considered and             segments of its commercial and consumer                    Institution E documents its decision to
the institution’s findings concerning these             loan portfolio for which it is probable that            include its loans to Company Y and
factors to be fully documented:                         the manufacturing business’ financial                   Company Z in its determination of its ALLL
   (1) Volatility of the market value of the            downturn has resulted in loan losses. In                under FAS 5. It also documents the specific
collateral                                              addition, Institution D should document its             characteristics of the loans that were the
                                                        analysis that resulted in the adjustments to            basis for grouping these loans with other
   19 In accordance with the FFIEC’s Federal            the loss rates for the affected portfolio               loans in Segment 1 and Segment 2,
Register Notice, Implementation Issues Arising          segments. As part of its documentation,                 respectively. Institution E maintains
from FASB No. 114, ‘‘Accounting by Creditors for        Institution D maintains copies of the                   documentation to support its method of
Impairment of a Loan,’’ published February 10,          documents supporting the analysis,
1995 (60 FR 7966, February 10, 1995), impaired,                                                                 estimating loan losses for Segment 1 and
collateral-dependent loans must be reported at the
                                                        including relevant newspaper articles,
fair value of collateral, less costs to sell, in        economic reports, and economic data.                      20 These groups of loans do not include any loans

regulatory reports. This treatment is to be applied        Because Institution D has had similar                that have been individually reviewed for
to all collateral-dependent loans, regardless of type   situations in the past, its supporting                  impairment under FAS 114 and determined to be
of collateral.                                          documentation also includes an analysis of              impaired as defined by FAS 114.

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                          Federal Register / Vol. 65, No. 174 / Thursday, September 7, 2000 / Notices                                                      54275

Segment 2, including the average loss rate             degree of management judgment and is                    impairment amount (as determined under
used, the analysis of historical losses by loan        inevitably imprecise. Accordingly, an                   FAS 114). The institution charged off the
type and by internal risk rating, and support          institution may determine that the amount of            ‘‘Loss’’ portion of the loan. After the charge-
for any adjustments to its historical loss rates.      loss falls within a range. An institution               off, the portion of the ALLL related to this
The institution also maintains copies of the           should record its best estimate within the              ‘‘Substandard’’ loan (1) reflects an
economic and other reports that provided               range of loan losses.22                                 appropriate measure of impairment under
source data.                                              Under GAAP, Statement of Financial                   FAS 114, and (2) is included in the aggregate
                                                       Accounting Standards No. 5, Accounting for              FAS 114 ALLL for all loans that were
Q&A #6—Consolidating the Loss Estimates—
                                                       Contingencies (FAS 5), provides the basic               identified for evaluation and individually
Documenting the Reported ALLL
                                                       guidance for recognition of a loss                      considered impaired. The aggregate FAS 114
   Facts: Institution F determines its ALLL            contingency, such as the collectibility of              ALLL is included in the institution’s overall
using an established systematic process. The           loans (receivables), when it is probable that           ALLL. End Text Box
accounting department prepares supporting              a loss has been incurred and the amount can                Large groups of smaller-balance
schedules that include the amount of each of           be reasonably estimated. Statement of                   homogeneous loans that are collectively
the components of the ALLL, as well as the             Financial Accounting Standards No. 114,                 evaluated for impairment are not included in
total ALLL amount, for review by senior                Accounting by Creditors for Impairment of a             the scope of FAS 114.24 Such groups of loans
management and the Credit Committee.                   Loan (FAS 114) provides more specific                   may include, but are not limited to, credit
Members of senior management and the                   guidance about the measurement and                      card, residential mortgage, and consumer
Credit Committee meet to discuss the ALLL.             disclosure of impairment for certain types of           installment loans. FAS 5 addresses the
During these discussions, they identify                loans.23 Specifically, FAS 114 applies to               accounting for impairment of these loans.
changes to be made to certain of the ALLL              loans that are identified for evaluation on an          Also, FAS 5 provides the accounting
estimates. As a result of the adjustments              individual basis. Loans are considered                  guidance for impairment of loans that are not
made by management, the total amount of the            impaired when, based on current information             identified for evaluation on an individual
ALLL changes. The supporting schedules are             and events, it is probable that the creditor            basis and loans that are individually
not updated to reflect the adjustments made            will be unable to collect all interest and
by senior management and the Credit                                                                            evaluated but are not individually considered
                                                       principal payments due according to the                 impaired.
Committee. When performing their audit of              contractual terms of the loan agreement.
the financial statements, the independent                                                                         Institutions should ensure that they do not
                                                          For individually impaired loans, FAS 114             layer their loan loss allowances. Layering is
accountants are provided with the original             provides guidance on the acceptable methods
ALLL supporting schedules that were                                                                            the inappropriate practice of recording in the
                                                       to measure impairment. Specifically, FAS                ALLL more than one amount for the same
reviewed by management and the Credit                  114 states that when a loan is impaired, a
Committee, as well as a verbal explanation of                                                                  probable loan loss. Layering can happen
                                                       creditor should measure impairment based                when an institution includes a loan in one
the changes made by management and the                 on the present value of expected future
Credit Committee when they met to discuss                                                                      segment, determines its best estimate of loss
                                                       principal and interest cash flows discounted            for that loan either individually or on a group
the loan loss allowance.                               at the loan’s effective interest rate, except
   Question: Are Institution F’s                                                                               basis (after taking into account all
                                                       that as a practical expedient, a creditor may           appropriate environmental factors,
documentation practices related to the                 measure impairment based on a loan’s
balance of its loan loss allowance                                                                             conditions, and events), and then includes
                                                       observable market price or the fair value of            the loan in another group, which receives an
appropriate?                                           collateral, if the loan is collateral dependent.
   Interpretive Response: No. An institution                                                                   additional ALLL amount.25
                                                       When developing the estimate of expected                   There are certain common elements an
must maintain supporting documentation for             future cash flows for a loan, an institution
the loan loss allowance amount reported in                                                                     institution should incorporate in its loan loss
                                                       should consider all available information               allowance methodology. Generally, an
its financial statements. An institution               reflecting past events and current conditions,
should document not only the determination                                                                     institution’s methodology should: 26
                                                       including the effect of existing environmental             (1) Include a detailed analysis of the loan
of the ALLL using its methodology, but also            factors. The following Illustration provides
any subsequent adjustments to the amount of                                                                    portfolio, performed on a regular basis;
                                                       an example of an institution estimating a                  (2) Consider all loans (whether on an
the ALLL and the rationale for those                   loan’s impairment when the loan has been
adjustments, such as adjustments made by                                                                       individual or group basis);
                                                       partially charged-off.                                     (3) Identify loans to be evaluated for
management or board committees as in the                  Begin Text Box—Illustration (Interaction of
circumstances described above.                                                                                 impairment on an individual basis under
                                                       FAS 114 With an Adversely Classified Loan,              FAS 114 and segment the remainder of the
Appendix B—Application of GAAP                         Partial Charge-Off, and the Overall ALLL): An           portfolio into groups of loans with similar
                                                       institution determined that a collateral                risk characteristics for evaluation and
  An ALLL recorded pursuant to GAAP is an              dependent loan, which it identified for
institution’s best estimate of the probable                                                                    analysis under FAS 5;
                                                       evaluation, was impaired. In accordance with               (4) Consider all known relevant internal
amount of loans and lease-financing                    FAS 114, the institution established an ALLL
receivables that it will be unable to collect                                                                  and external factors that may affect loan
                                                       for the amount that the recorded investment             collectibility;
based on current information and events.21 A           in the loan exceeded the fair value of the
creditor should record an ALLL when the                                                                           (5) Be applied consistently but, when
                                                       underlying collateral, less costs to sell.              appropriate, be modified for new factors
criteria for accrual of a loss contingency as          Consistent with relevant regulatory guidance,
set forth in GAAP have been met. Estimating                                                                    affecting collectibility;
                                                       the institution classified a portion of the                (6) Consider the particular risks inherent in
the amount of an ALLL involves a high                  recorded investment as ‘‘Loss’’ and the                 different kinds of lending;
                                                       remaining recorded investment as
  21 This Appendix provides guidance on the ALLL
                                                       ‘‘Substandard.’’ For this loan, the amount                24 In addition, FAS 114 does not apply to loans
and does not address allowances for credit losses      classified ‘‘Loss,’’ which was deemed to be
for off-balance sheet instruments (e.g., loan                                                                  measured at fair value or at the lower of cost or fair
                                                       the confirmed loss, was less than the                   value, leases, or debt securities.
commitments, guarantees, and standby letters of
                                                                                                                 25 According to the Federal Financial Institutions
credit). Institutions should record liabilities for
                                                         22 Refer to FASB Interpretation No. 14,               Examination Council’s Federal Register Notice,
these exposures in accordance with GAAP. Further
guidance on this topic is presented in the American    Reasonable Estimation of the Amount of a Loss, and      Implementation Issues Arising from FASB
Institute of Certified Public Accountants’ Audit and   Emerging Issues Task Force Topick No. D–80,             Statement No. 114, Accounting by Creditors for
Accounting Guide, Banks and Savings Institutions       Application of FASB Statements No. 5 and No. 114        Impairment of a Loan, published February 10, 1995,
(AICPA Audit Guide). Additionally, this Appendix       to a Loan Portfolio (EITF Topic D–80).                  institution-specific issues should be reviewed when
does not address allowances or accounting for            23 EITF Topic D–80 includes additional guidance       estimating loan losses under FAS 114. This analysis
assets or portions of assets sold with recourse,       on the requirements of FAS 5 and FAS 114 and how        should be conducted as part of the evaluation of
which is described in Statement of Financial           they relate to each other. The AICPA is currently       each individual loan reviewed under FAS 114 to
Accounting Standards No. 125, Accounting for           developing a Statement of Position (SOP) that will      avoid potential ALLL layering.
Transfers and Servicing of Financial Assets and        provide more specific guidance on accounting for          26 Refer to paragraph 7.05 of the AICPA Audit

Extinguishments of Liabilities (FAS 125).              loan losses.                                            Guide.

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54276                     Federal Register / Vol. 65, No. 174 / Thursday, September 7, 2000 / Notices

  (7) Consider collateral values (less costs to          Consolidated Reports of Condition and                      Nedlloyd Limited
sell), where applicable;                                 Income                                                  Pan American Independent Line
  (8) Require that analyses, estimates,                Interagency Guidelines Establishing                       Zim Israel Navigation Co., Ltd.
reviews and other ALLL methodology                       Standards for Safety and Soundness,
                                                                                                                 Mediterranean Shipping Co. S.A.
functions be performed by competent and                  established in 1995 and 1996, as amended
well-trained personnel;                                  on October 15, 1998                                     Euroatlantic Container Line S.A.
  (9) Be based on current and reliable data;           Interagency Policy Statement on the                       Senator Lines GmbH
  (10) Be well documented with clear                     Allowance for Loan and Lease Losses                     A.P. Moller-Maersk Sealand
explanations of the supporting analyses and              (ALLL), December 21, 1993                               Compania Sud Americana de
rationale; and                                         Joint Interagency Statement (regarding the                   Vapores, S.A.
  (11) Include a systematic and logical                  ALLL), November 24, 1998                                Evergreen Marine Corporation
method to consolidate the loss estimates and           Joint Interagency Letter to Financial                        (Taiwan) Limited
ensure the ALLL balance is recorded in                   Institutions (regarding the ALLL), March                Braztrans Transportes Maritimos
accordance with GAAP.                                    10, 1999
  A systematic methodology that is properly                                                                         Limitada
                                                       Joint Interagency Letter to Financial
designed and implemented should result in                Institutions (regarding the ALLL), July 12,
                                                                                                                 Compania Libra de Navegacao
an institution’s best estimate of the ALLL.              1999                                                    Synopsis: The proposed amendment
Accordingly, institutions should adjust their          Securities and Exchange Commission                      sets out the obligations of the members
ALLL balance, either upward or downward,                 Financial Reporting Release No. 28,                   with respect to the payment of
in each period for material differences                  Accounting for Loan Losses by Registrants             Agreement expenses and would permit
between the results of the systematic                    Engaged in Lending Activities, December
determination process and the unadjusted                                                                       the expulsion of members who fail to
                                                         1, 1986                                               meet those obligations.
ALLL balance in the general ledger.27                  Securities and Exchange Commission
                                                         Securities Act Industry Guide 3, Statistical            Agreement No.: 011426–030.
                                                         Disclosure by Bank Holding Companies                    Title: The West Coast South America
GAAP and Auditing Guidance                             Securities and Exchange Commission Staff                Discussion Agreement.
American Institute of Certified Public                   Accounting Bulletin No. 99, Materiality,                Parties:
  Accountants’ Audit and Accounting Guide,               August 1999                                             Crowley American Transport
  Banks and Savings Institutions, 1999                 Securities Exchange Act of 1934, Section
                                                         13(b)(2)–(7) (15 U.S.C. 78m(b)(2)–(7))
                                                                                                                 Seaboard Marine Ltd.
Auditing Standards Board Statement on                  United States General Accounting Office                   Columbus Line
  Auditing Standards No. 61,                             Report to Congressional Committees,                     Compania Chilena de Navegacion
  Communication With Audit Committees                    Depository Institutions: Divergent Loan                    Interoceania, S.A.
  (AICPA, Professional Standards, vol. 1, AU             Loss Methods Undermine Usefulness of                    APL Co. PTE. Ltd.
  sec. 380)                                              Financial Reports, (GAO/AIMD–95–8),                     P&O Nedlloyd B.V.
Emerging Issues Task Force Topic No. D–80,               October 1994                                            South America Independent
  Application of FASB Statements No. 5 and               Dated: August 30, 2000.                                    Association and its members:
  No. 114 to a Loan Portfolio (EITF Topic D–           Joanne M. Giese,                                          Trinity Shipping Line, SA
  80 and attachments), discussed on May 19–
  20, 1999                                             Assistant Executive Secretary, Federal                    Interocean Lines Inc.
Financial Accounting Standards Board                   Financial Institutions Examination Council.               Mediterranean Shipping Co. S.A.
  Interpretation No. 14, Reasonable                    [FR Doc. 00–22719 Filed 9–6–00; 8:45 am]                  South Pacific Shipping Company, Ltd.
  Estimation of the Amount of a Loss (An               BILLING CODE 6210–01–P (25%), 6714–01–P (25%)
  Interpretation of FASB Statement No. 5)              6720–01–P (25%), 4810–33–P (25%)                          Ecuadorian Line
Financial Accounting Standards Board                                                                             NYK/NOS Joint Service
  Statement of Financial Accounting                                                                              A.P. Moller-Maersk Sealand
  Standards No. 5, Accounting for                                                                                Compania Sud Americana de
  Contingencies                                        FEDERAL MARITIME COMMISSION
                                                                                                                    Vapores, S.A.
Financial Accounting Standards Board
  Statement of Financial Accounting                    Notice of Agreement(s) Filed                              Synopsis: The proposed amendment
  Standards No. 114, Accounting by                                                                             sets out the obligations of the members
                                                         The Commission hereby gives notice
  Creditors for Impairment of A Loan (An                                                                       with respect to the payment of
                                                       of the filing of the following
  Amendment of FASB Statements No. 5 and                                                                       Agreement expenses and would permit
                                                       agreement(s) under the Shipping Act of
  15)                                                                                                          the expulsion of members who fail to
Financial Accounting Standards Board                   1984. Interested parties can review or
                                                                                                               meet those obligations.
  Statement of Financial Accounting                    obtain copies of agreements at the
                                                       Washington, DC offices of the                             Agreement No.: 011722.
  Standards No. 118, Accounting by
  Creditors for Impairment of a Loan—                  Commission, 800 North Capitol Street,                     Title: New World Alliance/A.P.
  Income Recognition and Disclosures (An               NW., Room 940. Interested parties may                   Moller Maersk-Sealand Slot Exchange
  Amendment of FASB Statement No. 114)                 submit comments on an agreement to                      Agreement.
Financial Accounting Standards Board                   the Secretary, Federal Maritime                           Parties:
  Statement of Financial Accounting                    Commission, Washington, DC 20573,                         A.P. Moller-Maersk Sealand
  Standards No. 125, Accounting for                                                                              American President Lines, Ltd
  Transfers and Servicing of Financial Assets
                                                       within 10 days of the date this notice
                                                       appears in the Federal Register.                          APL Co. PTE Ltd.
  and Extinguishments of Liabilities
                                                         Agreement No.: 011421–024.                              Hyundai Merchant Marine Co., Ltd
Regulatory Guidance                                                                                              Mitsui O.S.K. Lines, Ltd.
                                                         Title: The East Coast South America
Federal Deposit Insurance Act, Section 39,             Discussion Agreement.                                     Synopsis: The agreement authorizes
  Standards for Safety and Soundness (12                 Parties:                                              the parties to exchange slot spaces on
  U.S.C. 1831p–1)                                                                                              each others vessels in the trade between
Federal Financial Institutions Examination               Crowley American Transport
                                                         Alianca Transportes Maritimos S.A.                    U.S. Atlantic and Gulf Coast ports and
  Council’s Instructions for Preparation of
                                                         Columbus Line                                         ports in Northern Europe.
 27 Institutions should refer to the guidance on         Lykes Lines Ltd., LLC                                   Agreement No.: 011723.
materiality in SEC Staff Accounting Bulletin No. 99,     APL Co. PTE. Ltd.                                       Title: New World Alliance Facilitation
Materiality.                                             P&O Nedlloyd B.V. and P&O                             Agreement.

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