In the aftermath of the 2008 financial crisis, regulators have made the Allowance for Loan and Lease Losses a point of emphasis, as a signal to indicate a financial institution’s ability to withstand and absorb the losses that have ensued. With over 400 bank failures since 2009, regulators interpret an inadequate ALLL as a key barometer of financial health, and as a result, they have been placing more pressure on surviving institutions to appropriately calculate adequate ALLL provisions.

1. How to support changes
in the ALLL reserve
Sageworks, Inc.
Ed Bayer
Regan Camp
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5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

2. In the aftermath of the 2008 financial crisis, regulators have made the Allowance for
Loan and Lease Losses a point of emphasis, as a signal to indicate a financial
institution’s ability to withstand and absorb the losses that have ensued. With over
400 bank failures since 2009, regulators interpret an inadequate
ALLL as a key barometer of financial health, and as a result, they
have been placing more pressure on surviving institutions to appropriately calculate
adequate ALLL provisions.
Many institutions have taken this pressure and regulator influence, along with fear of
past and perhaps future consequences, as motivation to increase their respective
ALLL provision. For some banks, this is likely needed, given the pitfalls of an
understated ALLL. However, it is important to follow accounting guidance to ensure
an accurate ALLL estimation, rather than increase it arbitrarily because of pressure
from regulators. As the OCC stated in March 1997:
“An understated ALLL expense will overstate the bank’s earnings and can
result in the violation of law;”
Conversely, an overstated ALLL expense can understate and limit the bank’s
earnings.1 Overstating an ALLL expense is not prudent to shareholders or boards of
directors nor is it, in light of recent pressure, recommended by regulatory guidance.
1
The Director’s Book: The Role Of The National Bank Director; The Office of the Comptroller of the Currency;
March 1997
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5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

3. Therefore, institutions may be asking:
“If I feel I have an overstated ALLL, how can I decrease my
provision?”
Before that question can be answered, it’s best to answer another question first –“As
a financial institution, am I following the guidance released in the 2006 Interagency
Policy Statement?”
The 2006 Interagency Policy Statement makes it clear that in order to estimate a
proper ALLL provision, the analysis of a financial institution’s loan portfolio should
be:2
• Comprehensive
• Well Documented
• Consistently Applied
• Inclusive of Environmental and Qualitative Risk Factors
Comprehensive
The ALLL calculation has become a cumbersome and complicated process given the
complexity of the loan portfolios at financial institutions. Excel, a widely used tool for
2
Interagency Policy Statement on the Allowance for Loan and Lease Losses; OCC, FDIC, NCUA, OTS, Fed Board of
Governors; 2006
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5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

4. determining the ALLL provision, is relatively weak and error-prone when it comes to
complex analyses. As such, relative to ALLL-specific solutions, Excel is not well
equipped to handle the complex reserve calculations that
are now necessary. Using a more comprehensive approach to calculating the
ALLL provision is one step to justify an ALLL decrease, and there needs to be a
process in place to support it.
A more comprehensive approach can be accomplished by one or more of the
options below:
• De novo institutions changing from peer group loss rates to true historical
loss rates after their de novo status ends.
• Moving from historical loss rates to migration analysis.
• Using automated software that provides more detailed analysis, which Excel is
unable to provide without incurring excessive costs or room for additional
error.
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5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

5. Proper Documentation
The Interagency Policy Statement also points out that a ‘well documented’ analysis is
required. This should seem intuitive in nature yet most institutions could still
improve. Undoubtedly, there is a cost to each institution, regardless of size, for
creating the documentation needed to support each ALLL calculation. Web-based
software can reduce the time required for the analysis and improve documentation.
It does so by maintaining existing impaired loan calculations, pulling in graphs from
the Federal Reserve Economic Data, showcasing past environmental factor changes
in accordance with changes in relativity data, and, in turn, proving directional
consistency in the institution’s ALLL calculation. The better documented an
institution’s ALLL calculation, the more evident it is that the calculation is sound,
justified, and in compliance with accounting guidance.
Consistency
Examiners and regulatory guidance call for a consistently applied analysis in
determining a financial institution’s ALLL reserve amount. This may seem like a
difficult obstacle if it requires a methodology change, such as peer groups to
historical loss rates, historical loss rate to migration analysis, or the move from using
an Excel-based calculation to implementing a web-based software solution. Yet,
regulatory guidance supports changes that result in a more
granular and detailed analysis. For example, a change to migration
analysis for larger banks is not only accepted by examiners, but it is also recognized
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5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

6. for its sophistication and accuracy. In fact, regulatory criticism is often reduced after
such a change, even with an outcome resulting in decreased ALLL provisions.
Similar experiences dictate that moving from a complex, manual set of multi-tab
Excel files to a software application can lead to less regulatory criticism. Software
solutions also provide a level of subject matter expertise
and eliminate a degree of human error through automation.
The structure of software encourages and makes it easier for better documentation,
along with more comprehensive and granular analysis, while reducing subjectivity
from environmental and qualitative factors.
Environmental and Qualitative Factors
Environmental and qualitative factors are vital to regulators’ guidance on a financial
institution’s ALLL provision. These factors are subjective in nature and are often the
area in an ALLL calculation most susceptible to examiner criticism. Therefore, it is
important to take action to limit the subjectivity while increasing objectivity. Using
any or all of the following six steps can significantly limit negative examiner
feedback, while improving your environmental and qualitative factor calculations:
• Follow Interagency Guidance
• Create a Standard Process of Review
• Utilize Current Market Information
• Ensure Directional Consistency
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5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

7. • Conduct Correlation Analysis
• Use Back-Testing as a Method of Validation
So, to repeat the question “How can a financial institution justify a decrease to their
ALLL provision?” The response is – An institution can justify a decrease if it’s
following the guidance released in the 2006 Interagency Policy Statement.
Institutions can further improve upon their ALLL and conduct a more
granular, robust ALLL provision analysis by moving to migration analysis, by
switching to ALLL-focused software, removing subjectivity in
environmental factors, or combining all these improvements.
This process very well may show a decrease in the required reserve. Will this raise an
examiner’s eyebrow? Likely. Teresa Curran, the director of banking supervision and
regulation for the Federal Reserve Bank of San Francisco, in June 2011’s ”Supervisory
Spotlight,“ noted that examiners watch certain areas more closely
when an ALLL decrease occurs.
Areas watched with greater scrutiny include:
• Showing adequate support for a reduction of the allowance due to improved
qualitative factors
• Studying impaired loan analysis for excessive optimism for cash flow
expectations.3
3
The ALLL Triple Play; Linda Keith CPA; 2011
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5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

8. However, the decrease in your reserve can be justified and supported by
regulatory and accounting guidance by:
• Performing a more detailed, robust analysis.
• Providing increased and richer documentation to strengthen the reasoning
behind your ALLL calculation.
• Maintaining a consistently applied ALLL procedure.
• Limiting subjectivity in environmental and qualitative risk factor calculations.
An institution shouldn’t necessarily aim to increase or decrease their ALLL provision.
But if a decrease in the reserve makes sense for a financial institution, the
recommendations outlined above, especially when combined, will help justify that
decrease and please not only shareholders and directors but also examiners.
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5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

9. About Sageworks
Sageworks, Inc. is a financial information company that works with financial
institutions, accountants, and private company executives across North America to
collect and interpret financial information. The mission of the company is to help
people make more-informed financial decisions in a business by giving them
information they can understand and use. Sageworks’ data, the largest database of
real time private company financial information in the U.S., grows as more than one
thousand reports are run each day, and the new data is screened and anonymously
incorporated into our industry statistics. We incorporate this data into our products
for financial institutions including credit analysis and ALLL estimation solutions.
About Ed Bayer
Ed Bayer is a Risk Management Consultant at Sageworks, where he serves as a
specialist in assisting financial institutions with accurately interpreting and applying
federal accounting guidance. Ed’s primary focus is allowance for loan and lease loss
provisions (ALLL) and stress testing loan portfolios. Before joining Sageworks, he
acted as president for a private holding company where he focused on new business
acquisitions, valuation models, federal taxation, and subsidiary business structures.
Prior to that, Ed served as a Financial Consultant with Merrill Lynch, graduating from
their Path of Achievement program. He received his MBA with concentrations in
strategy and entrepreneurship from Vanderbilt University’s Owen Graduate School of
Management, where he was a CLARCOR Scholarship Recipient, and he received his
bachelor’s degree from the University of Tennessee.
About Regan Camp:
Regan Camp is Risk Management Consultant at Sageworks, where he serves as a
specialist in assisting financial institutions with accurately interpreting and applying
federal accounting guidance. Regan focuses on the allowance for loan and lease loss
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5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com

10. provisions (ALLL) and stress testing loan portfolios. Prior to joining Sageworks,
Regan served as a Project Manager and Senior Consultant at Dittrich & Associates
LLC, where he assisted financial institutions in the administration of FDIC Loss Share
Agreements, the establishment of special asset divisions, and the resolution of
troubled portfolios. Prior to joining Dittrich, he worked at Deloitte and Touche, L.P.
as a Senior Consultant and Asset Manager. Regan received his bachelor’s degree
from Brigham Young University’s Marriott School of Business, where he studied
business management and finance.
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5565 Centerview Drive | Raleigh, NC 27606 | 866.603.7029 | www.sageworksinc.com