ACL Measurement for Collateral-Dependent Loans

ACL Measurement for Collateral-Dependent Loans

Allowance for credit losses (ACL) is a critical component of a bank’s financial and regulatory reporting. While U.S. GAAP under ASC 326-20 allows flexibility in how ACL is measured, regulatory reporting requirements are more specific when it comes to collateral-dependent loans. Some banks have mistakenly applied discounted cash flow (DCF) or probability of default/loss given default (PD/LGD) methods to collateral-dependent loans for regulatory reporting. However, regulatory guidance requires that the ACL for these loans be based on the fair value of the collateral. This post clarifies the correct approach and highlights examiner expectations.

Under U.S. GAAP, banks may use various methods to estimate expected credit losses, including DCF, loss-rate, roll-rate, or PD/LGD models. However, when a loan is deemed collateral-dependent, the accounting standard permits, but does not require, measurement based on the fair value of the collateral. In contrast, for regulatory reporting purposes, the OCC, Federal Reserve, and FDIC require that the ACL for collateral-dependent loans be measured using the fair value of the collateral, less costs to sell if applicable. This distinction is important for ensuring consistency with the Call Report instructions and interagency guidance.

Regulatory Background

Collateral-dependent loans are defined in regulatory guidance as loans for which repayment is expected to be provided substantially through the operation or sale of the collateral. The Interagency Policy Statement on Allowances for Credit Losses (2020) and the Call Report instructions both emphasize that for such loans, the ACL must be based on the collateral’s fair value. This requirement is consistent with long-standing regulatory expectations, even under the current expected credit loss (CECL) framework.

Examiner Focus Areas

During examinations, regulators will assess whether banks are applying the correct ACL measurement method for collateral-dependent loans. Key focus points include:

  • Proper Identification of Collateral-Dependent Loans: Examiners will review whether the bank has appropriately classified loans as collateral-dependent based on repayment expectations.
  • Use of Fair Value: For regulatory reporting, the ACL must be measured using the fair value of the collateral. Use of DCF or PD/LGD methods for these loans in regulatory reports is not acceptable.
  • Consistency with Call Reports: The ACL amount reported in the Call Report must reflect the fair value of collateral for collateral-dependent loans.
  • Documentation and Controls: Banks should maintain clear documentation supporting the classification of loans as collateral-dependent and the valuation of collateral used in ACL calculations.
  • Alignment Between GAAP and Regulatory Reporting: While GAAP may allow flexibility, banks must ensure that regulatory reporting aligns with supervisory expectations, particularly for collateral-dependent loans.

Best Practices for Compliance

To meet regulatory expectations, banks should establish internal controls that ensure the correct ACL measurement method is applied based on loan classification. This includes training credit and accounting staff on the differences between GAAP and regulatory requirements, and ensuring that systems and reporting tools can support both frameworks. Regular internal reviews or audits can help identify and correct any inconsistencies before they are flagged by examiners.

In summary, while CECL provides flexibility under U.S. GAAP, regulatory reporting for collateral-dependent loans remains grounded in the fair value of collateral. Banks must be careful not to apply general CECL methodologies, such as DCF or PD/LGD, to these loans for regulatory purposes. Doing so can result in examiner criticism and potential restatements of regulatory reports.

To learn more about how GLOBAL ABAS can support your compliance program, visit our website or subscribe for future updates.

Comments

Post a Comment

Popular posts from this blog

Third-Party Risk Management – Exam Expectations for Vendor Oversight

Image
Third-Party Risk Management – Exam Expectations for Vendor Oversight In June 2023, the federal banking agencies issued final Interagency Guidance on Third-Party Relationships, consolidating and replacing prior guidance from the OCC, Federal Reserve, and FDIC. This update, reflected in OCC Bulletin 2023-17, sets clear expectations for how banks should manage risk across the lifecycle of third-party relationships. Examiners now expect institutions to demonstrate strong governance, risk-based due diligence, and ongoing monitoring of all vendors, including fintechs, cloud providers, and affiliates. Whether a relationship is critical or not, banks must show they understand and control the risks introduced by third parties. Key Areas of Examiner Focus Risk-Based Due Diligence: Examiners expect banks to tailor their due diligence based on the risk and complexity of the third-party relationship. This includes evaluating financial condition, legal and regulatory c...
Read more

Key Examination Areas for Collateral-Dependent Loans

Image
Key Examination Areas for Collateral-Dependent Loans Collateral-dependent loans are a common focus during regulatory examinations, particularly when assessing credit risk and loan loss allowances. These loans rely primarily on the sale or operation of collateral for repayment, especially when the borrower is experiencing financial difficulty. Examiners from the OCC, Federal Reserve, and FDIC expect banks to have clear, well-documented processes for identifying, valuing, and managing these loans in accordance with U.S. GAAP and regulatory guidance. This post outlines the core areas examiners typically review and offers practical insights into meeting supervisory expectations. Understanding Collateral-Dependent Loans Under Accounting Standards Codification (ASC) 326-20-35-5, a loan is considered collateral-dependent when repayment is expected to come substantially from the collateral’s operation or sale, and the borrower is experiencing financial difficulty as of the reporting d...
Read more