1 GAAP Guidance - FAS 5 Accounting standard for loss contingencies Accounting standard for loss contingencies Requires accrual for an estimated loss if two conditions are met Requires accrual for an estimated loss if two conditions are met Applies to the estimation of credit losses on pools of loans, not to individually impaired loans Applies to the estimation of credit losses on pools of loans, not to individually impaired loans

2 For a loss to be accrued, two conditions must be met: It is probable that an asset has been impaired as of the date of the financial statements, and It is probable that an asset has been impaired as of the date of the financial statements, and The amount of loss can be reasonably estimated The amount of loss can be reasonably estimatedDefinition: Probable – The future event or events confirming the loss is likely to occur GAAP Guidance - FAS 5

3 Segment portfolio into pools of loans with similar risk characteristics, using one or more of the following: Risk classification or loan grade Risk classification or loan grade (e.g., Watch, Substandard, etc.) Past due status Past due status Loan type Loan type Industry Industry Collateral Collateral GAAP Guidance - FAS 5

4 Starting point is to determine historical loss rate (or range of loss rates) for each pool of loans with similar risk characteristics based on institution’s own loss experience for that pool Historical net charge-off rates generally used Historical net charge-off rates generally used Exceptions – De novo institutions, new loan products Exceptions – De novo institutions, new loan products Next, consider qualitative or environmental factors likely to cause estimated credit losses to differ from historical loss experience GAAP Guidance - FAS 5

5 Qualitative or environmental factors include –Changes in lending policies and procedures, underwriting standards, and collection practices –Changes in economic and business conditions –Changes in volume and severity of past due and adversely classified loans and in volume of nonaccrual loans –Changes in nature, volume, and terms of loans –Changes in lending management and loan review –Changes in underlying collateral values –Effect of concentrations and changes in levels GAAP Guidance - FAS 5

6 Reflect overall effect of qualitative factors on a loan pool as adjustments that increase or decrease the historical loss rate on the pool Reflect overall effect of qualitative factors on a loan pool as adjustments that increase or decrease the historical loss rate on the pool Alternatively, reflect effect of qualitative factors through separate standalone adjustments within FAS 5 component of the ALLL Alternatively, reflect effect of qualitative factors through separate standalone adjustments within FAS 5 component of the ALLL Evaluating effect of qualitative factors requires significant judgment because data to determine precise impact of factors may not be reasonably available or directly applicable Evaluating effect of qualitative factors requires significant judgment because data to determine precise impact of factors may not be reasonably available or directly applicable GAAP Guidance - FAS 5

7 If a range of loss rates is developed for a pool of loans, determine which rate is the best estimate from within the range. For each pool of loans, apply its adjusted historical loss rate (or its historical loss rate and separate standalone adjustments) to the recorded investment in the pool to determine the FAS 5 allowance allocation for each pool. GAAP Guidance - FAS 5

8 Maintain supporting documentation for historical loss rate (or range of loss rates) developed for each pool of loans To support qualitative adjustments, maintain reasonable documentation explaining how adjustments reflect current information, events, and conditions GAAP Guidance - FAS 5

9 FAS 5 Analysis: For homogeneous loans that were not individually reviewed, the following retail credits were classified based on delinquency status: 17 Residential mortgages$1,324 Substandard 28 Consumer auto loans$ 248 Substandard $ 16 Loss 12 Unsecured consumer I/Ls$ 102 Substandard Illustration Example A

10 FAS 5 Analysis: Management segments the portfolio and compiles three-year historical loss data (based on net charge-offs to the ALLL) for each segment of the portfolio Management segments the portfolio and compiles three-year historical loss data (based on net charge-offs to the ALLL) for each segment of the portfolio As of the analysis date, historical loss rates for the segments were: As of the analysis date, historical loss rates for the segments were: –Commercial loans % –Commercial real estate loans - 0.5% –Residential mortgages % –Consumer auto loans % –Unsecured consumer installment loans % –Loans fully secured by deposits in bank % Illustration Example A

11 FAS 5 Analysis: FAS 5 Analysis: Management also assesses current environmental factors and as of the balance sheet date found that: Management also assesses current environmental factors and as of the balance sheet date found that: –Due to an oversupply in commercial space in its trade area, occupancy rates have declined over the past year. The bank had faced similar market conditions before and losses on commercial real estate loans during those periods were about 10% higher than usual. –In the past year, several local employers have reported earnings problems and two had already had lay-offs. Management estimates these factors have caused losses to rise on all consumer loans by 10%, on residential mortgages by 6%, and on commercial loans by 7% compared to the prior three- year period. Management based these estimates on the increase in loans in day delinquency status in each portfolio segment since the lay-offs began. Illustration Example A

12 FAS 5 Analysis: Adjusted loss factors developed for the general loan pools: Commercial loans0.546% Commercial real estate loans0.55% Residential mortgages0.2968% Consumer auto loans 0.33% Unsecured consumer installment loans0.462% Illustration Example A

13 FAS 5 Measurement: Commercial loans $23,000 x 0.546%= $125.6 Commercial real estate lns$14,400 x 0.55%= 79.2 Residential mortgages $25,825 x %= 76.6 Consumer auto loans $ 3,784 x 0.33%= 12.5 $ 16 x 100%= 16.0 $ 16 x 100%= 16.0 Unsecured consumer I/Ls$ 700 x 0.462%= 3.2 Total FAS 5 estimated losses measured= $ Illustration Example A

14 Total Allowance Estimate: FAS 114$ FAS Total$1,068.1 Illustration Example A

15 ALLL Balance $1,068.1 CRE Loan # 1 confirmed Loss CRE Loan # 1 confirmed Loss CRE Loans # 2 & # 3 confirmed Loss CRE Loans # 2 & # 3 confirmed Loss Residential Mortgage # 4 Loss Residential Mortgage # 4 Loss Consumer Auto loss Consumer Auto loss _______ Net total ALLL $920.1 Illustration Example A