Loan Performance

The workpaper shows the optional treatment of eliminating prime rated loans from the nonidentified risk pool. An alternative treatment of reviewed and graded loans would be the assignment off different anticipated loss factors to loans depending on the credit quality grade. Institutions which employ an "A," "B," "C," Substandard Doubtful Loss risk rating system may elect to assign, for example, 65 basis point loss factors to "C" graded loans and 55 basis point factors to those graded "B." The correlation of loss factors and credit quality grades will depend on the institution's definition of grades and their loss experience with each grade. .

Other Loses

At some institutions, losses unrelated to lending activity may be provided for as a part of the loan reserve balance. Included in these types of transactions may be permanent write-downs due to credit risk on investments, losses occurring from overdrawn accounts, and losses occurring in negotiable instruments handling. An adjustment to the provision will be required in institutions that recognize these types of losses on a reserve basis.

Adequacy Assessment

The sample workpaper adjusts the book balance of the reserve by 2,896 thousand based on identified loss with an additional adjustment of 972 thousand based on nonidentified loss. The threshold level which alerts management that an additional funding is required will vary between institutions. The adjusted balance in this example is shown at a deficit position indicative of the necessity for an additional provision.

Conclusion:

The proposed method, if carefully developed with management, independent auditors, and lenders, may help to document a valid attempt by the institution to meet financial accounting pronouncements that require periodic assessment of the adequacy of the loan loss reserve. The empirical methodology proposed will need to be tempered with the sound judgment of lenders and management who are familiar with the specific characteristics of the lending area and the bank's underwriting philosophy. The internal auditor may also want to work with the institution's independent public auditors in developing the parameters of the loan loss adequacy workpaper :