EVALUATING A BANK'S LOAN LOSS RESERVE ADEQUACY

Consumer Debt

Consumer loan credit quality is most often measured by performance. The nature of this type of lending (a large number of relatively small credits) normally precludes a loan-by-loan analysis of the entire portfolio. Federal banking regulators have established guidelines for determining the ultimate collectibility of consumer loan portfolios. Guidelines established by the "Uniform Classification of Consumer Debt" stated that loans over 120 days past due, less the net realizable value of associated collateral, are accorded a loss classification. A hypothetical figure of thirty thousand is shown in Section A of the adequacy workpaper. Internally generated delinquency reports provide a good source document for this analysis. Nonidentified consumer loan loss may be measured as a function of the portfolio size and the institution's historical loss experience. The quantification of this factor is shown in Section B of the workpaper. The consumer loan portfolio in this instance is segregated by type of consumer debt, and a unique loss factor is applied to each segment based on the experience of the institution. The internal auditor may wish to adjust the experience loss factor for anticipated changes in the lending environment or the institution's underwriting standards. Both the identified and nonidentified loss are used as adjustment factors to lower the book balance of the loan loss reserve.

Real Estate Loans

Real estate secured loans, like consumer loans, are often measured by performance. Collateral value in real estate lending is a significant factor in net collectibility evaluations. Loss experience tends to be less likely on real estate secured lending, particularly if the collateral is residential real estate. The loss identification techniques employed on real estate loans tends to be more judgmental than those used on consumer loans. Accurate evaluations of the net realizable value of the collateral are essential to loss estimates. Specifically identifiable losses are shown in Section A of the workpaper, while those not identified are shown in Section B. Both values are again used to adjust the reserve balance. Another potential source of loss associated with real estate lending are those former or current loans carried as "other real estate." This category of risk asset may include loans pending foreclosure or those where the title has been obtained and a sale is sought by the bank. Because higher risk is generally found in these assets, the technique used to identify loss is individual parcel review. The primary objective of parcel review is to establish the fair value of the subject real estate. Perhaps the most valid technique for determining the fair value is a recent independent appraisal. If an appraisal is not evident, establishment of value may be accomplished by the income approach. Discounting of future cash flows on other real estate should follow the "fair value" concept after the foreclosure has occurred. Conservatism is essential with parcel review, and the avoidance of asset overstatement must be emphasized. Losses noted during this examination can generally be specifically identified, as indicated in Section A of the workpaper. :

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