Jeff Judy

Jeff's Thoughts - January 20 , 2010

Is ALLL Well with You?

There's little doubt that examiners are scrutinizing your financial statements like never before, given the ups and (mostly) downs of our industry in the last couple of years, and the still fragile nature of any recovery from recent events. There may be even less doubt about the single most interesting number, from their point of view, among all the figures to be found in your statements.

The Allowance for Loan and Lease Losses, or ALLL, is a unique element in your financial statements. It differs from all the other lines to be found in your balance sheet and income statement both in timeframe and in its very nature.

First, I have spent a lot of time in the classroom over the past few decades teaching beginning bankers to look at the balance sheet as a snapshot of a particular moment in time. The income statement, on the other hand, is a reflection of events over the recent past, what has happened up to the moment the statement is constructed.

But the ALLL entry is about the future. It is, in essence, a prediction of what may happen in the months or year ahead.

Which brings me to my second point: as a prediction, ALLL is the result of a conscious decision, a deliberately chosen amount that reflects -- or should reflect -- management's beliefs about what is going to happen in the future. While all the other numbers in the financial statements are results, the outcomes of past actions, ALLL is largely a choice.

We now know that many financial institutions made the wrong choice about how to set this allowance, and in some of those institutions, management failed to grasp the predictive, forward-looking nature of ALLL. After all, if you looked at the economy as a whole, the picture was very prosperous for a long time. A bank that managed their reserves solely by looking at recent and current conditions, while times were good, would make little effort to boost those reserves to prepare for troubled times that they should have seen coming, but that hadn't arrived just yet.

Basically, banks typically set aside ALLL in one of four ways:

  1. They make what they hope is an educated guess about what will be needed.
  2. The set ALLL on the low side, to improve their other numbers, and hope they won't really need it.
  3. The set ALLL high enough so they don't have to worry about it, although that has an impact on their cash flow.
  4. They do the research and analysis to set ALLL at an optimal level to balance risk protection against cash flow, operating resources, and profits.

Frankly, I can assure you that most institutions chose Option #1 above, the educated guess, partly because that's how it had always been done, and partly because they didn't know what else to do. And as the recession revealed, more than a few chose the second option, #2, keeping ALLL low and hoping for the best. We all know how that worked out.

A few leading institutions have gone the route of collecting data, analyzing their portfolios carefully over time, thinking more objectively about this critical number on the balance sheet. They are still making predictions, and they are still using history to guide those predictions, but they are making much better informed predictions, and getting better results.

Remember, the bank examiners are making predictions about what your ALLL should be, too. And there is no quicker way to get their focused attention than to have a wide gap between what they think is a reasonable prediction, and what you plug into your balance sheet.

In future issues of Jeff's Thoughts, I'll have more tips on how to build a solid foundation for your ALLL predictions, a foundation that will be good for your business at the same time it is persuasive to your examiners.