Management of loan loss reserves by commercial bankers--part 1

Journal of Bank Cost & Management Accounting, The, 1996 by Joyce, William B

Other Large Loans 50,000 250 Problem Small Commercial Loans 4,000 40 Problem Small Consumer Loans 3,000 60 Small Commercial Loans 2,000 40 Consumer Loans 1,500 30 Total Estimated Reserve $2,000 In general, loans are divided at a minimum into large classified loans, other large loans, and smaller commercial and consumer loans.

For most banks, the majority of large loans (those that are significant in relation to bank capital or total loans) are found in the commercial loan portfolio. Classified loans are those that have been placed in higher-thannormal risk classes either by the bank's internal loan review or by the examiners. A bank's entire portfolio of large loans is frequently reviewed to determine which loans present greater-than-average risk and should therefore be classified, or whether those loans already classified should be unclassified or moved to a higher risk category. Classified loans are scrutinized more carefully than other loans when determining reserves for loan losses.

An expected loss or range of losses for all classified loans for each risk class may be estimated from two bases: first, the past year's losses and recoveries for that class of loans, and second, from knowledge of the individual classified loans, or from a combination of both. A reserve need is computed for each loan or class of loan as the product of the probability of loss of the loan or class times the dollar amount of the expected loss. Some of the factors banks typically considered when deciding the probability of amount of loss from a classified loan are the following: whether the loan is currently past due, and if so, how far past due; the financial condition of the borrower; the availability of responsible cosigners or guarantors; the availability of collateral and its value; and national and regional trends as well as industry trends.

The losses inherent in the portfolio of other large loans (large loans that are not classified) must also be estimated to determine the amount of reserves needed for these loans. The estimate is based on historical loss data for large loans with normal risk and classified by type of loan; knowledge of the credit-worthiness of the individual borrowers; and the economic and industry trends.

Expected losses on small commercial loans and consumer loans that are not past due or on non-accrual status are estimated from loss histories of the various types of loans and from other considerations that may influence losses in the future. For example, a bank may have suffered losses ranging from two to four percent per year of its credit card portfolio over the past five years. It would be reasonable, therefore, for the bank to maintain reserves for credit card loans in a range form from two to four percent of the average amount of the bank's outstanding credit card loans (assuming conditions affecting losses on such loans to be unchanged in the coming year).

Managers are given flexibility for low value, high volume loans. Regulators may require banks to hold reserves only for the coming year's expected losses, rather than holding reserves for expected losses over the entire life of these low value, high volume loans, which may exceed one year. If rising unemployment or some other factors, which might increase losses, are expected in the coming year, the amount of reserves needed for these loans would be higher.