1. Accounting Update Part 2 Chicago Regional Training Conference Indianapolis, Indiana June 14, 2006 Robert F. Storch, Chief Accountant Division of Supervision and Consumer Protection Federal Deposit Insurance Corporation Washington, DC

2. Allowance for Loan and Lease Losses Agencies’ most recent guidance on the allowance for loan and lease losses (ALLL) Issued 3/1/04* –Institutions are responsible for ensuring that controls are in place to consistently determine the ALLL in accordance with GAAP, their stated policies and procedures, and supervisory guidance –Institutions should develop, maintain, and document a comprehensive, systematic, and consistently applied process to determine the amounts of the ALLL and provisions * www.fdic.gov/news/news/financial/2004/fil2204a.html

3. Allowance for Loan and Lease Losses –Institutions must maintain an ALLL at a level that is appropriate to absorb estimated credit losses inherent in the loan portfolio –Arriving at an appropriate allowance involves a high degree of management judgment and results in a range of estimated losses –A prudent, conservative, but not excessive, ALLL that represents management’s best estimate from within an acceptable range of estimated losses is appropriate

4. Allowance for Loan and Lease Losses Lists existing ALLL guidance that institutions should apply, including –FAS 5 and FAS 114 –EITF Topic D-80 –AICPA Audit and Accounting Guide: Depository and Lending Institutions –1993 Interagency Policy Statement on the ALLL –July 1999 Joint SEC-Banking Agency Letter to Financial Institutions –2001 Interagency Policy Statement on ALLL Methodologies and Documentation for Banks and Savings Associations / SEC SAB 102

5. Allowance for Loan and Lease Losses 1993 Interagency Policy Statement –Outlines factors to be considered in ALLL analysis –Analysis should cover each component of the portfolio, based on similar characteristics, and should include all significant credits on an individual basis –Indicates that ratio analysis, including comparison to peer averages, is a supplemental tool for evaluating ALLL reasonableness, but is not a sufficient basis for determining ALLL adequacy

6. Allowance for Loan and Lease Losses 1993 Interagency Policy Statement –Provides that examiners will generally accept management’s estimates in their assessment of the adequacy of the ALLL when management has: Maintained effective systems and controls for identifying, monitoring, and addressing asset quality problems in a timely manner Analyzed all significant factors affecting the collectibility of the portfolio in a reasonable manner Established an acceptable ALLL evaluation process

7. Allowance for Loan and Lease Losses July 1999 Joint SEC-Banking Agency Letter –Third joint letter issued by the banking agencies and the SEC www.fdic.gov/news/news/press/1999/pr40attach.html –Communicates six fundamental ALLL concepts, including “Unallocated” allowance is appropriate only when it reflects an estimate of probable losses, determined in accordance with GAAP, and is properly supported All available information, including environmental (industry, geographic, economic, and political) factors, should be considered

8. Allowance for Loan and Lease Losses 2001 Interagency Policy Statement on ALLL Methodologies and Documentation –ALLL documentation should Support the ALLL process and methodology Support amounts of the ALLL and provisions reported in financial reports Be appropriate for the size and complexity of the institution, while complying with GAAP –Institutions with minimal or no support for the ALLL will likely be subject to criticism and possible supervisory action

9. Allowance for Loan and Lease Losses 2001 Interagency Policy Statement on ALLL Methodologies and Documentation –Written policies and procedures should document the methodology for: Segmenting the portfolio Determining and measuring impairment of loans evaluated individually under FAS 114 Determining and measuring impairment of pools of loans with similar characteristics under FAS 5

10. Allowance for Loan and Lease Losses ALLL Checklist Are effective loan review/credit grading systems in place? Are loans deemed uncollectible promptly charged off? Are policies and procedures in place that describe how the loan portfolio is segmented? Does the ALLL evaluation include an analysis of impairment for individual loans under FAS 114? Are individual FAS 114 impairment determinations and measurements of impairment well documented and supported?

11. Allowance for Loan and Lease Losses ALLL Checklist Does the ALLL evaluation include an analysis of impairment for pools of loans under FAS 5? Are FAS 5 loss rates reasonable, well supported, and incorporate historical loss experience and other factors? Is the ALLL analysis performed by management and reviewed by the Board at least quarterly? Does the reported ALLL level on the balance sheet differ significantly from the most recent quarterly calculation?

12. Allowance for Loan and Lease Losses Examiners should expect bank management to: –Be familiar with the 2001 Policy Statement on methodologies and documentation –Comply with GAAP for the ALLL For example, if bank has not, in practice, adopted FAS 114, management should commit to begin doing so –Bring bank’s methodologies and documentation practices into compliance with the 2001 Policy Statement to the extent necessary For example, if bank has not developed historical loss data for segments of its portfolio, a first step should be for the bank to begin developing such statistics

13. Allowance for Loan and Lease Losses Revision of the Interagency Policy Statement on the ALLL –Issued in 1993 before FAS 114 took effect and before issuance of SOP 03-3 –At best, ambiguous with respect to treatment of off-balance sheet credit exposures –Also predates 2001 policy statement on ALLL methodologies and documentation –Interagency project is under way to revise the 1993 policy statement

14. Allowance for Loan and Lease Losses Draft revision of policy statement notes that –ALLL is an institution-specific amount that is determined based on a comprehensive analysis of the loan portfolio and the factors affecting collectibility –Changes in level of ALLL should be directionally consistent with changes in factors evidencing credit losses If credit quality is declining, ALLL as percentage of portfolio should increase If credit quality is improving, ALLL as percentage of portfolio should decrease

15. Allowance for Loan and Lease Losses Revision would eliminate policy statement’s existing provision advising examiners to check reasonableness of institution’s reported ALLL against sum of 50% of doubtful, 15% of substandard, and estimated credit losses over upcoming 12 months for rest of portfolio based on average annual net charge-offs, adjusted for current conditions and trends –Although policy says this amount is neither a "floor" nor a "safe harbor" level for an institution's ALLL, it has too often been used as one, including by bankers

16. Allowance for Loan and Lease Losses Agencies also developing a set of frequently asked questions about the ALLL that would accompany revised policy statement Agencies plan to share drafts of revised policy statement and FAQs with FASB, SEC, and PCAOB prior to finalizing them No current plans to seek public comment

17. Allowance for Loan and Lease Losses PCAOB and the ALLL –PCAOB issued public portions of inspection reports on accounting firms in late 2005 and early 2006 –Several firms specifically criticized for a lack of documentation to support their audits of ALLLs, particularly the more judgmental aspects of “unallocated” ALLLs

18. Allowance for Loan and Lease Losses “In each of these audits, the Firm failed to obtain sufficient evidence, or failed to include sufficient evidence in its work papers, that the unallocated component of the allowance represented a supportable estimate of probable losses inherent in the issuer's loan portfolio.”

19. Allowance for Loan and Lease Losses “Each issuer's allowance for loan losses ("ALL") had three components: (i) a calculation based on historical losses for homogenous loans; (ii) adjustments for specific groups of loans; and (iii) unallocated reserves, which are not allocated to any specific loans, groups of loans, or specific risks. The second and third components, which are subject to significant management judgment, were greater than 40 percent of each issuer's ALL. The Firm did not perform sufficient audit procedures to conclude that the second and third components were appropriate since it did not test the reasonableness of the assumptions in management's and the Firm's own calculations.”

20. Allowance for Loan and Lease Losses What does this mean for banks? –Banks should continue to improve their own ALLL documentation, particularly their adjustments for qualitative and environmental factors that are based on management’s judgment