Jeff Judy

Jeff's Thoughts - August 18 , 2010

Chatting About ALLL/Capital with your Regulators

It is no secret that the Allowance for Loan and Lease Losses, ALLL, is of keen interest to regulators these days. And that is to be expected, based on recent history.

It is most certainly the case that many banks took a casual, almost routine, approach to setting aside reserves, and that those reserves turned out to be woefully inadequate when the economy took a tumble. With the ALLL shortfall, capital became the "reserve to the reserves," and so capitalization has been, and remains, under relentless scrutiny by the regulators.

In the face of this pressure, both from the regulators and from the basic need to ensure their survival, banks have been paying more attention to their reserves and capital. But banks that fail to make a deliberate, focused effort to revise their system for maintaining adequate reserves may not be making things much better for themselves.

To some extent, setting reserves at just the right level to achieve appropriate risk management without being too great a drain on operating funds will always be an "educated guess." We cannot predict the future perfectly, and the ALLL number you plug into your financial statements will always be, at least in part, a judgment call.

But too many banks are focused on the wrong end of their "educated guesses". In response to regulatory and business pressures, they are trying to "make a better guess" when they should be concentrating on "improving their education" about where their portfolios are headed.

I have written in the past (see below) about the importance of collecting data you can use to make better informed judgments about what your portfolio, and especially the weaker segments of your portfolio, will look like in the next couple of years. Even some very basic data can give you a much better foundation for your "educated guess" about how your lending relationships will end -- in full repayment, partial repayment, or as charge-offs. This kind of "Terminal Risk Analysis" can make it much more likely that you will hit the "sweet spot" when you set reserves, protecting against ugly surprises, but not locking up resources over aggressively, to the detriment of your growth as a business.

It can also make a huge difference in the tone of your conversations with regulators.

One thing you do not want to do is let the regulators dictate your reserves and capital. If you think you have no choice but to swallow their recommendations, that may be because you don't have the solid data you need to argue your case.

In many banks, the back and forth with regulators about reserves is a contest of wills. It comes down to whether your belief in your guess about future needs is strong enough to sway their belief that you are not doing enough.

In banks where they have developed a body of data, and a systematic way of drawing conclusions from those data, there are grounds for discussion. Better information gives the bank additional leverage in persuading regulators that different numbers might be suitable.

And even if you do not win every argument with the regulators about your reserves, the very fact that you have taken the time to design a data-based approach to setting reserves is evidence of a well-run bank. Just being able to engage in the discussion at a more objective level distinguishes you from the pack, leaving regulators to spend more time on banks that are just guessing.

If you want more control over both your future and your present, take a serious look at the data you may have already collected about your portfolio's history, and at what steps you need to take to collect better data on trends in your portfolio going forward. Your future will be more secure, and your present more manageable, if you make the investment of attention, time, and resources to ensure you apply more education and less guesswork to ALLL and capital in your bank.