top insights into the loan loss reserve methodology of banks
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Top insights into the loan loss reserve methodology of banks
Loan loss reserve stands for the contra-asset account on a financial institution’s balance sheet which is netted against gross loans. The loan loss reserve is incremented by the value of loan loss provision in every quarter and decremented by the quantity of net charge-offs.
Need for loan loss reserve validation
The llr methodology is subjected to review to ascertain its compliance to regulatory guidelines, rationality in determining the reserve allocations and ensure reflection of the same through proper statement in the financial institution’s loan policy.
Determining loan loss reserve
The adjustment of bank’s loan loss reserve is carried out every quarter contingent on the projected interest loss in the institution’s net loan portfolio inclusive of performing and nonperforming ones.
Loan loss reserve methodology may vary from bank to bank, but the loan loss reserve pertaining to lesser balance homogenous loans are typically ascertained by factoring in groups of similar loan types that share similar credit attributes. Various analytical models are embraced which investigates in depth the contributing
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factors, primarily the projected loss severities, experienced loss frequencies and historical delinquency terms. The reserves for loans take into account the portfolio’s inherent losses which are projected to be discerned in the 12 months to follow.
Credits in loan loss reserve validation which
emerges with a rating of 1 to 11 are declared ‘pass’,
credits with rating 12 are assigned ‘pass watch’, 13
gets ‘special mention’, 14 is ‘substandard’, 15 becomes
‘doubtful’, and 16 is ‘loss’. The total of 13, 14, 15 and
16 are collectively defined as ‘criticized’ loans. Further,
loan classification also takes place under the header of
FAS 114 impaired loans. Loss reserves are then finally
established in consideration of the loan type and grade,
migration trends and severity of loss. The experience
that took place most recently is assigned most weight.
A third party reviewer conducts analyzing, testing and
validation of the methodology that underlies the
general and specific loan allocations. The portfolio
experience of the past 3 to 10 years are taken into
consideration which involves study of loan grades
migration, robustness of the loan grading system,
alterations in portfolio mix, and loss experience.
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Further, portfolio risks trends are also analyzed in
consideration of the concentrations like loan and
collateral types, large loan exposures, loan policy
maintenance, and industry and loan grades. Other
factors that are pertinent to the portfolio profile such as
off balance sheet commitments, delinquency and non-
accrual trends and peers loss experience are also
factored in. The observations and conclusions provide
valuable insights to fortify the loan loss reserve
validation and increase timely loan recovery.
Loan Loss Reserve Methodology and Validation (LLR
Methodology) by CEIS Review -
http://www.ceisreview.com/pages/Services/2/149/Metho
dology_Validation
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