Tom Brown on loss reserve adequacy

by PlanMaestro

Several questions on this issue. I have nothing to add.

For instance, the two most misleading measures of loss reserve adequacy are 1) the ratio of loss reserves to nonperforming assets, and 2) the ratio of reserves to nonperforming loan percentages. Sure enough, these two metrics are the favorites of many analysts and journalists.

Why are the numbers misleading?  First, they are overly mechanistic. The reserve is built through backward-looking formulas that take into account the institution’s loan mix, its loan grades, and its historic loss rate by loan type for all of its loans, not just the nonperforming loans.

Second, any additional writedown or loss on the disposition of OREO does not come out of the loan loss reserve. Instead it shows up as an expense.  Remember the titles: “loan loss reserve” and “other real estate owned.”  Once a bank possesses the property or other collateral, that property is no longer a loan. It’s an asset. Any further value decline, therefore, cannot come out of the loan loss reserve.

Gauging Banks’ Loan Loss Reserve Adequacy: The Basics