Reducing the ALLL Reserve for Thrifts
The Office of Thrift Supervision (OTS) may be long gone, but the institutions that it once regulated are still around and dealing with some of its legacy issues.
OTS supervision formally ended in July 2011, when approximately 670 thrifts were moved over to the Office of the Comptroller of the Currency (OCC) resulting in problems for those institutions in properly calculating the Allowance for Loan and Lease Losses (ALLL) reserve. When formerly OTS banks experienced their first OCC examination, many of them found that their current ALLL calculation and methodology failed to meet expectations.
One of the most problematic differences between an OTS ALLL calculation and one conducted by the OCC was the timing of charge-offs related to a FAS 114 (ASC 310-10-35) collateral impairment analysis. Previously, OTS-regulated banks were not required to implement a partial or complete charge-off once a collateral impairment was recognized.
Upon transitioning to the OCC, several banks faced immediate charge-offs, with some impairments dating back to the 2008-2009 financial crisis and beyond. Whether the new OCC banks had to complete a partial or full charge-off with the transition, the sudden change in allowance levels required increased provisions and a decrease in bank net income.
Decreasing ALLL Levels
Despite the regulatory concern, there are two justifications for the current rapid retreat of ALLL reserves: improved lending and fewer enormous charge-offs impacting FAS 5 loss ratios.
Since the end of the financial crisis, there has been a general improvement in loan quality. With smaller organic loan growth and improved asset quality, the number of impaired loans in a given bank has decreased and has limited the number of loans requiring a charge-off. This environment has created fewer specific reserves and fewer future charge-offs, therefore reducing future quantitative loss ratios.
At the same time, ALLL reserves have decreased due to the falloff of significant charge-offs from FAS 5 loss ratios. This has been a significant contributor to ALLL decreases among banks formerly regulated by the OTS and has created problems with their new OCC examiners. Guidance from the OCC requires an immediate charge-off once an impairment is recognized. This change, when compounded by the financial crisis and coinciding with the new OCC bank’s first examination, led to a significant increase in write-downs during the first OCC examination for these thrifts.
In fact, the percentage of charge-offs for formerly OTS banks would have been notably larger during this first examination cycle period than that of a bank that had always been OCC-regulated. This requirement caused formerly OTS institutions’ ALLL reserve rates to increase drastically, in several cases more than doubling (even tripling). This historical period, whether measured by year or quarter, created challenges that formerly OTS institutions are still struggling with today.
Formerly OTS-regulated banks have a few options to help smooth out the ALLL rate. They include drawing a negative provision; using an unallocated reserve; manipulating qualitative factors; and extending the FAS 5 loss ratio’s lookback period. Unfortunately, examiners have been apprehensive about both a negative provision and using an unallocated allowance. This has created quite the conundrum for formerly OTS-regulated banks that are trying to handle such a large and immediate decrease in their FAS 5 loss ratios.
While adjusting qualitative risk factors is technically acceptable, it can be difficult to justify at a time when almost all data that supports the qualitative factors (such as unemployment index, vacancy rates and housing price index) show improvement and would suggest a decrease in those factors. Choosing this option may lead to an inflated ALLL reserve in the downturn of an economic cycle, i.e., data would continue to support an increase in the qualitative factors, along with additional specific reserves and higher loss ratios.
The remaining option for former OTS institutions is to extend their FAS 5 loss ratio lookback period from the average eight to 12 quarters to the maximum period allowed by regulatory guidance: five years or 20 quarters. While this large of a lookback period may fall outside the norm, it is well within regulatory guidance and can be justified to examiners and auditors. The extension of a lookback window allows the bank to achieve a more accurate representation of a full economic cycle.
However, there are two drawbacks to implementing a longer-term lookback window. First, this solution may only delay the problem faced today with the eight-to-12-quarter lookback period, especially if current charge-off rates remain low. At some point, the large charge-off required during the transition will drop out of the lookback period.
Second, the alteration of the lookback window goes against the 2006 Interagency Policy Statement, which requires a consistently applied methodology to build a sound, defensible and justified ALLL reserve. So, while this option – altering the lookback window – may be the best option of the four, the “consistent methodology” defense is lost and could raise red flags if examiners deem the ALLL reserve to be too low or the calculation to be inadequately performed.
To those considering this option, it is important to consider that examiners are, on occasion, asking banks to change their lookback period, usually to a period that will maximize their reserve, which is not consistent with guidance. In theory, the best method would be to always utilize a lookback period that includes a full economic cycle, while allowing for weighting based on the current point in the cycle.
There has been little guidance provided on this particular challenge of accounting for the change in ALLL. And, a resolution from OCC examiners is unlikely. OTS banks undoubtedly have to adapt to the heightened risk management expectations of the OCC and this includes diversifying their portfolio from mostly 1-4 family residential mortgages to more commercial lending.
Rather than make these adjustments, some institutions, in extreme cases, have converted into a credit union or become state-chartered. Yet, other formerly OTS banks have met the OCC’s match, oftentimes leveraging software solutions or consultants to assist with the more complicated risk management requirements of the OCC, including requirements around the ALLL, stress testing and even financial disclosure reporting.
Regardless of the system chosen, banks that made the switch from the OTS to the OCC will find success by reviewing guidance and, more importantly, working to interpret and implement feedback from their new examiners.