FASB 5 and FASB 114 - Regolators' Take

On the interagency Q&A, it states
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Question # 3
If an institution concludes that an individual loan specifically identified for evaluation is not impaired under FAS 114, should that loan be included in the assessment of the ALLL under FAS 5?

Answer:
Yes, generally, that loan should be evaluated under FAS 5. If the specific characteristics of the individually evaluated loan that is not impaired indicate that it is probable that there would be an incurred loss in a group of loans with those characteristics, then the loan should be included in the assessment of the ALLL for that group of loans under FAS 5. Institutions should measure estimated credit losses under FAS 114 only for loans individually evaluated and determined to be impaired.
Under FAS 5, a loss is recognized if characteristics of a loan indicate that it is probable that a group of similar loans includes some estimated credit losses even though the loss cannot be identified to a specific loan. Such a loss would be recognized if it is probable that the loss has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. (EITF D-80, Question 10).

Question # 4
If an institution assesses an individual loan under FAS 114 and determines that it is impaired, but it measures the amount of impairment as zero, may it include that loan in a group of loans collectively assessed under FAS 5 for estimation of the ALLL?

Answer:
No. For a loan that is impaired, no additional loss recognition is appropriate under FAS 5 even if the measurement of impairment under FAS 114 results in no allowance. One example would be when the recorded investment in an impaired loan has been written down to a level where no allowance is required. (EITF Topic D-80, Question 12).
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With these in mind, let's say there is a loan fully secured by a commercial real estate and it defaulted on the payment for over 90 days. It is then placed into non-accrual and becomes subject to FASB 114 impairment analysis. The loan is concurrently downgraded to Substandard for which, let's say, the reserve factor is 15%. The general reserve of 15% is set aside for this loan.

It turns out that the loan is not impaired under FASB 114 analysis. According to the above regulatory guidelines, should the general reserve of 15% be reversed or not? In other words, if a loan is not assessed to be impaired under FASB 114, should it be subject to FASB 5 again and maintain a general reserve? Anyone?

Question # 3
If an institution concludes that an individual loan specifically identified for evaluation is not impaired under FAS 114, should that loan be included in the assessment of the ALLL under FAS 5?

Answer:
Yes, generally, that loan should be evaluated under FAS 5.

I think you answered your own question.

FAS 114 defines "impairment" as follows: " ... based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement." In your scenario, presuming the loan is still on non-accrual, then the loan is still impaired -- as management believes the bank will not collect all of the contractual interest. And in your scenario, presuming the collateral is sufficient to recover the loan principal, then you should reverse the 15% reserve allocation. And in conclusion, you should not subject this loan to the FAS 5 reserve calculation.

However, your comment about the loan not actually being impaired confuses me a bit. Are you implying the loan collateral is adequate and no impairment (i.e. reserve) is required? If so, then my comments above still apply. But if you imply the loan is no longer impaired based on the definition of "impairment" provided by FAS 114, then you should consider returning the loan to accrual status and, at such point, the loan should be included in the FAS 5 reserve calculation.

On a side-note, I picked-up on something when you equated a 15% reserve with a substandard loan. Be careful that your bank does not "automatically" assign arbitrary reserve percentages to classified loans (e.g. 10% reserves on Special Mention loans, 25% reserves on Substandard loans, etc.). GAAP and Interagency Guidance require banks to calculate the actual impairment using cash flow models or collateral values. If your bank can provide documentation to support a 15% reserve allocation for Substandard loans, then you're fine. Otherwise, be wary of this practice. A lot of banks do it, but I've observed a lot of banks being criticized for the practice as well.

Dazed: My current position is at a much smaller, less complicated place than I have ever worked before. The 5%, 15%, 25% arbitrary reserves for classified loans has worked for them before and they have never been criticized.

I have helped them monitor their historical losses and other loss predictors for FAS 5 analysis and they are considering all classified loans as subject to FAS 114. The problem is that at times, the valuation analysis shows that there is no reason to reserve any more than on performing loans. Mgmt just isn't satisfied with going from 15% to the FAS 5/performing level.

Any thought on stratifying FAS 5 for non-performing loans? We're chatting about this again later this week and I would appreciate any input.

It's just a first for me working at a bank where the substandard loans aren't subject to a higher reserve than the performing loans. (And it also doesn't help that I have two CPAs arguing that the std percentages we've been using are so much better than the ranges utilized by other banks they've seen.)

It's quite possible that you could have a $-0- reserve for a substandard loan (or other classified loan). If a non-performing loan is classifed as substandard and placed on non-accrual, then management believes that it will not collect all of the contractual interest on the loan --- thus, it is impaired (i.e. subject to FAS 114). If the net realizable value of the collateral on this same loan is estimated to cover the unpaid principal (and any interest not reversed), then technically speaking, the FAS 114 reserve should be $-0- (and this loan should not be subject to FAS 5 reserves).

I'm aware of several smaller community banks (assets below $100 million) that tack-on arbitrary reserves to classified loans that really do not need the reserves ... but management does it anyway because they feel compelled to allocate a reserve simply because the loan is classified and simply because "that's how it's been done for years." In a sense, these banks are over-reserved ... but I have yet to see a federal or state regulator require a bank to take a negative provision (i.e. decrease its allowance). Rather, regulators strongly encouraged these banks to provide written, qualitative analysis to support the need for the excess reserves.

In my experiences, I believe the regulators hold larger, more-complex institutions to a higher standard in regard to their allowance calculations and methodologies, and offer more flexibility and lenience to smaller, non-complex institutions. But I have seen a recent trend by the regulators to get the smaller community banks "on board" with the technical application of GAAP and Interagency Guidance for allowance calculations and methodologies --- it's just a slow learning process that takes time. Also, it seems that capital adequacy, asset quality and management effectiveness play a big role in the regulators' approach as well.

Thanks Dazed. We had a good meeting on this topic. Mgmt and the BOD are comfortable with the process but ARE having a hard time letting go of those std percentages from their smaller days.

We should be subject to exam in the near future and could stand a little tweaking of those well-collateralized FAS 114 loans.