EVALUATING A BANK'S LOAN LOSS RESERVE ADEQUACY

Types of Loan Loss

Evaluation of the loan loss reserve will present the internal auditor with the prospect of considering two types of loan losses: those which can be specifically identified (Section A of the workpaper), and those that are anticipated (as a result of experience and peer group data), but which can't be specifically identified at the review date (Section B of the workpaper). The ability to quantify estimates of each loss type is critical to the substantive testing process. The bank's past loss experience for each type of loan is the best guide for estimating the unidentified loss. However, this experience must be tempered with anticipated changes in underwriting standards, economic climate, or geographic limits. The knowledge of lending personnel and management will be extremely helpful in establishing expected loss factors. Additional industry and peer group data on historical losses are available through regulatory agencies, trade associations, and private concerns, such as Robert Morris Associates. These sources may also be valuable in forming loss estimates.

Loss Analysis

Typical bank loan portfolios may be segregated into three loan types: consumer loans, real estate secured loans, and commercial loans. The techniques for evaluating the loss potential for each type of debt differs, depending on the characteristics of the subject loan. While specific analytical techniques will vary with the loan type in each instance when the loan appears uncollectible, the analysis will attempt to measure the unpaid balance and the future value of remaining repayment sources. The terms "net realizable value" (N.R.V.) and "fair value" are used many times in the determination of collateral valuation. According to accounting literature, net realizable value is used to determine loss on troubled loans with fair value after foreclosure or repossession has occurred. In both fair value estimates and net realizable value estimates, future cash flows are discounted. Fair value concept discounts are based on the institution's borrowing cost and entrepreneurial profit, while N.R.V. is based on the institution's simple cost of capital to hold the asset. Since a fair market rate will include risk, it will always exceed the simple cost of funds rate making losses based on fair value exceed that calculated on N.R.V. :