On December 13, 2006, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision (the “banking agencies”), and the National Credit Union Administration (NCUA) issued the attached Interagency Policy Statement on the Allowance for Loan and Lease Losses. This guidance updates and replaces the 1993 Interagency Policy Statement on the Allowance for Loan and Lease Losses (SR Letter 93-70). The agencies revised the prior policy to ensure consistency with generally accepted accounting principles (GAAP) and more recent supervisory guidance. Additionally, the agencies issued a supplemental Frequently Asked Questions document to assist with application of the revised policy statement.
The revision updates the previous policy statement’s description of the responsibilities of boards of directors, management, and examiners of banking organizations regarding the allowance for loan and lease losses (ALLL); factors to be considered in the estimation of the ALLL; and the objectives and elements of an effective loan review system, including a sound credit grading system. The revised policy statement emphasizes that each institution is responsible for developing, maintaining, and documenting a comprehensive, systematic, and consistently applied process for determining the amounts of the ALLL and the provision for loan and lease losses. To fulfill this responsibility, each institution should ensure controls are in place to consistently determine the ALLL in accordance with GAAP, the institution’s stated policies and procedures, management’s best judgment, and relevant supervisory guidance.
The revised policy reiterates the points of agreement between the Securities and Exchange Commission and the banking agencies since 1999: the need for management to exercise significant judgment when estimating the ALLL, the concept of a range of losses, and the appropriateness of a properly developed and documented ALLL. Accordingly, the policy emphasizes that an institution should provide reasonable support and documentation of its ALLL estimates, including adjustments to the allowance for qualitative or environmental factors and unallocated portions of the allowance. This emphasis on support and documentation supplements, but does not replace, the guidance in the Interagency Policy Statement on the Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions (SR Letter 01-17).
Additionally, the policy reminds institutions that the allowance is an institution-specific estimate and generally should not be based solely on a “standard percentage” of loans. While peer group or other benchmark averages are an appropriate tool to evaluate the reasonableness of the allowance, it is the institution’s responsibility to analyze the collectibility of the loan portfolio to estimate the allowance. To that end, the policy statement will no longer reference standardized loss estimates (i.e., 15% for loans classified as substandard and 50% for loans classified as doubtful).
The revised policy also includes guidance on SFAS 114, Accounting by Creditors for Impairment of a Loan, which describes the evaluation and measurement of impairment for loans that are impaired on an individual basis, and SFAS 5, Accounting for Contingencies, which describes the same for pools of loans grouped according to risk factors. The revised language describes the relationship between the two standards as well as the application of each standard in estimating the ALLL.
The policy also reminds institutions that allowances related to off-balance sheet financial instruments such as loan commitments or letters of credit should not be reported as part of the ALLL. Any allowance for these types of instruments is recorded as an Other Liability.
Although the revised policy statement reiterates key concepts and requirements in GAAP and existing supervisory guidance on the ALLL, the agencies recognize that institutions may not have sufficient time to complete any enhancements needed to bring their ALLL processes and documentation into full compliance with the revised guidance for year-end 2006 reporting purposes. Nevertheless, these enhancements should be completed in the near term.
This policy statement applies to all depository institutions supervised by the banking agencies and to institutions insured and supervised by the NCUA, except for U.S. branches and agencies of foreign banks. In addition, the Federal Reserve believes the guidance is broadly applicable to bank holding companies as well. Accordingly, examiners should apply the policy, as appropriate, in the inspection of bank holding companies and their nonbank subsidiaries, in addition to the examination of state member banks. Examiner training materials are being updated to reflect the new policy statement. U.S. branches and agencies of foreign banks continue to be subject to any separate guidance that has been issued by their primary supervisory agency.
Reserve Banks are asked to distribute a copy of this SR letter and the policy statement to appropriate members of senior management of all bank holding companies and state member banks. Questions pertaining to this policy statement may be directed to Sharon Ramsay, Supervisory Financial Analyst, at (202) 452-2028, Arthur Lindo, Deputy Associate Director, at (202) 452-2695, or Charles Holm, Associate Director and Chief Accountant, at (202) 452-3502.