Jeff Judy

Jeff's Thoughts - March 17 , 2010

ALLL: Are You Post- or Pre-Cyclical?

Few numbers are more indicative of, or more crucial to, your financial health than is the Allowance for Loan and Lease Losses, or ALLL. It is not only a core element of risk management, setting aside the reserves you will need to deal with problems that could crop up in the future. It is a delicate balancing act, between reserving enough to provide protection, but not overdoing it and thus putting otherwise productive funds out of action.

When the economic downturn hit, many banks -- including quite a few that are no longer with us -- discovered, either on their own or with the help of the regulators, that they had tried to get by with too small an Allowance. When credit losses mounted, they didn't have enough to fall back on to get them through a bad patch.

In many of these institutions, frankly, that was simply the result of neglect. Management at some banks saw ALLL as a necessary evil, something they were forced to deal with, and they only gave it sufficient attention to find the bare minimum they thought they could get away with. They more or less set it and forget it, until it came back to bite them.

While I don't have a great deal of sympathy for those institutions, I am concerned about many banks where they honestly intend to adjust ALLL appropriately, but still may find themselves in difficult straits when they miss the mark. These are banks where they have failed to understand the timing relationship between ALLL and the broader business cycle.

First, it doesn't hurt to remind ourselves that banking is a cyclical industry like any other. Second, ALLL is a "bet" placed on the future. It is a prediction of where the cycle is going next. Funds are set aside so they will be there to draw upon in bad times.

That implies that the way to set ALLL is to look at what you think will happen next, in the economy and in your portfolio. But many, perhaps the majority, of institutions base ALLL on the numbers they have now, not the numbers they expect to have in the next period.

Sometimes their approach is as simple as crunching together other numbers from the financial statements, and then pegging ALLL to a percentage of that index. This results in what I call a "post-cyclical ALLL," meaning that your ALLL number will lag behind the business cycle, rather than anticipate it, as it should.

Recent history shows us how this works (or doesn't work, in many cases). As the economy gets stronger and stronger, defaults become rare, and ALLL keeps shrinking. Bank management sees smaller and smaller loan losses, and sets smaller reserves in response.

Then the economy flips upside down, and those minimal reserves are completely overwhelmed.

No doubt many unemployed bank managers now wish that they had foregone a bit of the heady profits of the boom times, and saved a bit more for the very rainy days that arrived with the recession. They wish they had been "pre-cyclical" in setting ALLL to reflect what was coming, not what has been and gone.

Risk management is an anticipatory business. Getting through tough times results from having prepared for those conditions. Going pre-cyclical with ALLL, adjusting your Allowance based on what you believe the next cycle will bring, can, very simply, save your bank.

In a coming issue of Jeff's Thoughts, I'll share some of the steps you can take to get ahead of the ALLL cycle.