12/30/2022 0 Comments What Is a Loan Loss Allowance?The allowance for loan and lease losses is a calculated reserve of bad debts within an institution. It is determined as a proportion of the estimated credit risk of its assets. Volatility affects loan loss allowances In a nutshell, a loan loss allowance is a nonaccrual line item that reduces retained earnings. When a bank decides to add an allowance to a nonaccrual, it reduces its pretax net income by the allowance minus the nonaccrual line item. A similar ratio is used by regulators to assess banks' asset quality risk. The regulatory focus on nonaccruals is reflected in a requirement to disclose additions to nonaccruals in regulatory reports. For example, the Financial Accounting Standards Board (FASB) recently released a proposal to move away from the traditional taxpayer-backed deposit insurance model and require that nonaccrual assets be included in the calculation of loan loss allowances. However, the net benefits of this change are unclear. Some analysts argue that the regulation's reliance on the loan-loss-additions-to-nonaccruals ratio to measure nonaccruals is the wrong way to go. While the ratio provides a useful signal, it's not always possible to measure a flow variable without measurement errors. One of the best ways to overcome this problem is to use alternative timeliness estimates. In their analysis, Basu, et al., use a number of plots to sift through data to generate hypotheses. Their key finding is that the loan-loss-additions-to-nonaccruals-ratio is not the most important measurement. Instead, they argue that the allowance-to-nonaccruals-ratio, along with other reductions, captures the true cost of changes in nonaccruals. To help them make their case, Basu, et al., used a simulation model to study the effects of additions to nonaccruals. They found that a 3% increase in a loan loss allowance's value is worth a 7% decrease in retained earnings. Although this may seem like an overstatement, the authors say it is a worthwhile tradeoff. If a bank can avoid this tradeoff, it will likely feel more comfortable absorbing losses. Similarly, supervisors hope that each dollar of an additional allowance for a loan will increase their ability to absorb losses. Finally, the aforementioned model is not the only one. Beatty and Liao (2011) have a very similar model, but use a different approach. By utilizing a mixture of the allowance-to-nonaccruals-ratio and the timeliness measure, they achieve a much better result. LTC or LTV ratios and DSCR ratios are indications of risk Loan-to-cost ("LTC") and debt service coverage ratio ("DSCR") ratios are important economic indicators used by lenders. These two metrics indicate how much of a company's income is dedicated to paying its debt obligations. If a company's DSCR is low, it's a signal that its income may not be sufficient to pay its debt obligations. Similarly, if a lender's DSCR is high, it's a sign that the borrower is a strong credit risk. This type of risk is generally higher than other types of risk. LTC or LTV is the relative value of a loan to a project's cost. The less a loan to cost ratio, the more equity a company has in the project. Generally speaking, lenders use the lower of these numbers as an indication of a company's risk. DSCR is a more comprehensive financial indicator, analyzing a company's performance over a 12-month period. It's considered one of the most comprehensive metrics for evaluating a company's long-term health. Often, companies will calculate DSCR monthly to monitor its trend. Some lenders will require a borrower to maintain a minimum DSCR. For example, if a borrower has a DSCR of 0.95, it means that the borrower can't afford to pay ninety-five percent of the amount owed on a loan each year. Normally, lenders frown on loans that show negative cash flow, as the borrower must dip into personal funds every month. But some lenders will allow negative cash flow if the borrower has sufficient resources. A DSCR of 1.1 or less is generally a sign of a company's vulnerability to loss. Likewise, a DSCR of 1.25 is a sign of strength. When used in conjunction with a loan-to-value or loan-to-cost ratio, DSCR is a useful tool for determining the amount of cash flow available for a given loan. DSCR is often used in negotiating a loan contract. Depending on the company's industry, stage of growth, and competitors, DSCR expectations can vary. Companies that are larger, mature, and established typically have higher DSCR expectations. However, smaller companies can expect a DSCR of 1.0 or less. Overall, lenders and analysts use DSCR as a measure of a company's financial strength. DSCRs are a good indicator of how a company's ability to pay off its debt obligations will be over the long term. LEADt is a leading indicator for loan loss allowances during the post-crisis period The leading indicator for loan loss allowances, or LEADt, is a measurement of the sensitivity of nonperforming loans to changes in the economy. Although this is a standard indicator for loan loss allowances, there are some differences in how it is calculated and how it affects the cyclicality of bank lending. A number of studies have investigated the sensitivity of loan loss allowances to changes in the economy, including the relationship between loan losses and property prices. Others have examined the effect of different impairment rules on loan and lease losses. Other researchers have examined whether banks with excess capital boost their provisions or take other countercyclical actions. In this paper, we examine the cyclicality of provisioning and use a specification test to evaluate the extent to which it is influenced by the current state of the business cycle, asset quality, and forward-looking indicators of economic activity. Using a sample of the largest U.S. holding companies, we find that loan loss allowance rates were lower during the post-crisis period than in the pre-crisis period. We also find that the allowances of non-adopter banks decreased more during the crisis than the allowances of CECL adopters. In the pre-crisis period, loan loss allowances were positively correlated with nonperforming loans. During the crisis, however, the negative relationship between nonperforming loans and allowances was statistically significant. This suggests that allowances are drawn down during credit busts. Banks that adopted the CECL were able to significantly reduce their allowances across their portfolios. However, this result may not have been a result of the new standard. Instead, it may be the result of the fact that they are required to report additions to their nonaccruals. It is unclear, however, how this impact affects the sensitivity of nonperforming loan allowances. Whether the sensitivity of provisioning is affected by the survivor bias of banks is unclear. Some researchers have used reported data to measure the sensitivity of nonperforming loans, ignoring the increased sensitivity of nonaccruals during a credit bust. They have also tried to test whether longer delays in the recognition of expected losses lead to a decline in loan growth and lending. Impact of nonperforming loans on loan loss allowances Nonperforming loans affect loan loss allowances in different ways during different economic cycles. The impact of nonperforming loans on loan loss allowances is higher during periods of high unemployment, low interest rates, and a real estate crisis. It is also lower during a normal business downturn, such as during the Great Recession of 2008-2010. Several researchers have examined the effects of different drivers on the cyclicality of loan losses. Some have focused on delays in the recognition of expected losses, while others have examined whether banks with higher earnings and excess capital boost their provisions. Researchers have also considered the relationship between loan loss allowances and macroeconomic variables, such as property prices. However, determining the sensitivity of provisions to the change in nonaccruals can be a difficult task. One important factor contributing to the asymmetry in the relationship between provisioning and nonaccruals is the degree of loan heterogeneity. This is primarily due to the fact that nonaccruals are not standardized across bank holding companies. As a result, the effect of nonperforming loans on loan loss allowances can be highly variable. For example, during the pre-crisis boom period, the coefficients on nonperforming loans were positive, whereas the coefficients during the crisis period were negative. In this way, the asymmetry persists in model estimates. However, in the post-crisis period, the coefficients on nonperforming loans are lower. Despite the asymmetry, the sensitivity of provisioning to nonaccruals remains significant. Nonaccruals are measured at delinquent payments and full outstanding loan balances, while allowances are measured at impaired value and collateral fair value. These measurements are influenced by the state of the economy, but also by other factors such as survivorship bias and lagged provisioning. Although it is ideal, this is not always feasible. Another approach is to use alternative timeliness estimates. This method, used by Beatty and Liao (2011), calculates the loan loss allowance balance divided by the total nonperforming loan balance. This ratio is similar to the allowance-to-naccuracy ratio used by regulators. Because the two ratios are similar, this method has the advantage of not introducing measurement errors when nonaccruals changes. Finally, an asymmetric approach is proposed by Basu et al. (2020). They believe that the larger the net charge-offs, the more likely there will be large increases in loan loss provisions. During the financial crisis, this assumption led to a higher provisioning rate.
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