EVALUATING A BANK'S LOAN LOSS RESERVE ADEQUACY

IN EVALUATING THE FINANCIAL strength of any credit-granting institution, the adequacy of the institution's loan loss reserve is a primary consideration. Financial accounting pronouncements clearly place the burden of establishing a sufficient level of reserves with management. Evaluation of the controls surrounding the reserve process, and, in many cases, substantive testing of the reserve balance itself, are often delegated to the bank's internal auditor. The recent savings and loan debacle has highlighted the need for all financial institutions to incorporate a comprehensive measurement system to assess the adequacy of the loan loss reserve. External reviewers of financial institutions will question the validity of earnings unless evidence is available that the loan loss reserve has received a proper provision

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Evaluation Factors

A direct comparison of the relative size of the loan loss reserve and the loan portfolio is probably the most utilized technique for evaluating the reserve. Banking regulators and external reviewers often cite a one percent ratio as the bench mark for adequacy. This ratio technique, considered necessary in the evaluation process, will yield reliable results only if combined with additional factor analysis. Assessment of the credit quality of the loan portfolio is critical to the loan loss adequacy determination. Quality factors may include performance, concentrations, types of collateral, loan to value ratios, and borrowers' repayment capacity. A well-defined and adhered-to loan policy is the initial step in achieving satisfactory marks on the credit quality factors. Internal auditors faced with the challenge of attempting to evaluate the loan loss reserve might well start with compliance testing of the underwriting policy and standards. The bank's lending policy sets the underwriting tone for the institution's practices relative to credit initiation. The importance of the policy document requires periodic review from both executive management and the board of directors. Policy tenets which are considered critical to limit risk in loan underwriting include geographic limits, distribution by category, maximum maturities, loan pricing, maximum loan to value ratios, required financial information, and loan authority. The internal auditor may wish to establish that each of these elements is included in the institution's policy and then conduct substantive tests for adherence to the policy requirement. :