EVALUATING A BANK'S LOAN LOSS RESERVE ADEQUACY

Commercial Loans

Commercial loans generally are larger extensions of credit and represent the highest level of risk in the portfolio and, therefore, deserve the internal auditor's most stringent review during the loan loss evaluation process. A provision for both identifiable and nonidentifiable loss is provided in the respective sections of the workpaper (Exhibit).

A well-administered loan review function that assigns credit quality grades to the loans reviewed is indispensable to the internal auditor's analysis. It is hoped that this process will recognize any loss in the commercial portfolio. Before the internal auditor accepts the findings of the loan review function, testing of loan review internal controls may be desirable. If reliance appears warranted, the output from an independent loan review function becomes an integral part of the loan loss adequacy workpaper. Other sources of loss identification data include reports of examination from banking regulatory agencies and the previous work of the institution's independent public accountants. Because the loan review process and the resultant credit grading are involved so heavily with the auditor's opinion of loan loss adequacy, it may be beneficial to briefly summarize the elements of the review process. Three factors are involved with the determination of an individual commercial debt's collectibility: performance, ability to service the debt, and the strength of any underlying collateral. :

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