Expert Model for Assessing Asset Quality



Auszug aus dem Uniform Bank Performance Report (Federal Financial Institutions Examination Council):

Expert Model for Assessing Asset Quality

Asset quality is a critical part of your financial analysis of an institution because it directly impacts the evaluation of other components such as capital, earnings, and liquidity. Asset quality often weighs heavily on conclusions regarding management and a bank’s overall condition.

This expert model provides guidance for completing two analyses for asset quality:

• An off-site analysis of UBPR data, which involves three steps:

1. Review the balance sheet structure

2. Identify the types and levels of off-balance sheet items

3. Analyze the levels and trends of key ratios

• An on-site analysis, in conjunction with the examination team, to follow up on off-site concerns and review the bank’s assets for credit risk. This includes analyzing three additional ratios that are computed once the asset review team determines adverse classifications.

Off-Site Analysis 2

Step 1. Review Balance Sheet Structure 2

Step 2. Identify types and levels of off-balance sheet items 2

Step 3. Analyze levels and trends of key ratios 3

– Net Loss to Average Total LN & LS 3

– Earnings Coverage of Net Loss(x) 3

– LN & LS Allowance to Total LN & LS 4

– Non-current LN & LS to Gross LN & LS 4

– Recoveries to Prior Credit Loss Ratio 5

– Net Losses by Type of LN & LS Ratios 5

– The summary of non-current loans and leases at the top of page 8 6

– The percentage of non-current loans and leases by loan type, shown on the remainder of page 8 and page 8A 6

On-Site Analysis 8

– Adversely classified items coverage ratio 8

– Total adversely classified assets to total assets ratio 8

– Total adversely classified LN & LS to total LN & LS ratio 8

Asset Quality Evaluation Factors and Rating Definitions 9

OFF-SITE ANALYSIS

Step 1. Review the balance sheet structure

A review of the bank's balance sheet structure will give you an overall picture of the bank's asset composition and help you identify any assets that expose the bank to credit risk.

|Review these UBPR pages: |To determine: |

|Pages 4 – Assets, Liabilities and Capital and 6, |The bank's overall asset and liability composition. Identify assets representing the largest portion of average assets. In general, loans have|

|Balance Sheet - Percentage Composition of Assets |more credit risk than securities. |

|and Liabilities | |

|Page 7A, Analysis of Loan & Lease Allowance and |The mix of loans in the bank's loan portfolio. Loans represent the majority of most banks' asset structures and ordinarily present the greatest |

|Loan Mix |amount of credit risk. Different types of loans carry different amounts of credit risk. For example commercial loans present more credit risk |

| |than 1-4 family residential mortgage loans. Banks that have a higher percentage of commercial loans expose themselves to a greater possibility |

| |of credit risk. |

|Page 10, Liquidity and Investment Portfolio. |The distribution of the bank's securities portfolio. U.S. Treasury and Government agency securities present the least amount of credit risk. |

| |Other domestic debt securities (e.g., corporate bonds, municipal securities, trust-preferred securities, and collateralized mortgage obligation |

| |(CMO) traunches) could expose the bank to greater credit risk. If you identify other domestic debt securities, you will want to examine them |

| |further during the on-site analysis to assess their risks and ensure management is properly monitoring and controlling these risks |

Step 2. Identify the types and levels of off-balance sheet items.

Review page 5 of the UBPR to determine the types and levels of off-balance sheet activity. There are three primary off-balance sheet items that could expose a bank to increased credit risk:

• Unfunded commitments

• Letters of credit

• Assets securitized or sold with recourse

If these items are noted on the UBPR, follow up with management during the on-site analysis to assess its approach to these activities and the magnitude of the credit risk involved.

Step 3. Analyze the levels and trends of key ratios

The key asset quality ratios are central to your off-site analysis of asset quality. Understanding the ratios will help you interpret the bank’s overall condition and will point out areas for follow up while on-site. The key ratios are found on UBPR pages 1, 7, 8, and 8A.

Summary Ratios: UBPR Page 1

|Ratio and Calculation |Analysis |

|Net Loss to Average Total LN & LS |This ratio shows the annualized level of net loan and lease losses relative to the average volume of total loans. Consider the: |

| |Level. In general, a lower ratio indicates less credit risk in the loan portfolio. However, keep in mind that UBPR data is based on what the |

|Total of LN& LS |bank reports. If management is not reporting or recognizing loan losses, a low ratio may not reflect the actual level of risk. A higher ratio |

|charge-offs – gross recoveries |may not always be indicative of excessive risk in the loan portfolio; rather it could mean that management is taking a conservative approach by |

|Average total LN & LS |aggressively recognizing losses. |

| |Trend. If the most recent ratio is significantly higher or lower than those reported in prior periods, further on-site investigation is |

| |warranted. |

|Earnings Coverage of Net Loss(x) |This ratio indicates the bank's ability to absorb potential losses through core earnings. Consider the: |

| |Level. A higher ratio is better because it indicates a greater ability to absorb potential losses through earnings. If the ratio is less than 1,|

|Net operating income before taxes, securities |the bank's earnings will not cover its losses, either because the bank's losses are so high that they exceed earnings or because net operating |

|gains or losses, |income is so low that it does not cover the losses. |

|and extraordinary items + |Trend. Changes to the bank's operating income or volume of loan losses influence this ratio. For example: |

|provision for LN & LS losses |If the bank increases its net operating income, the ratio will likely increase, indicating an enhanced ability to absorb loan and lease losses |

|Net LN & LS losses |If the bank experiences an increase in loan and lease losses, the ratio will likely decrease, indicating a reduced ability to absorb losses |

| |through earnings. |

Summary Ratios: UBPR Page 1 (continued)

|Ratio and Calculation |Analysis |

|LN & LS Allowance to Total LN & LS |This ratio shows how much cushion exists in the allowance for loan and lease losses (ALLL) account to absorb losses within the loan and lease |

| |portfolio. Consider: |

|The ALLL balance |The level. A higher ratio indicates a greater ability to cover loan losses. This ratio will vary significantly depending on the bank's lending |

|Total LN & LS |activities and portfolio quality. |

| |The trend. In general you want to see this ratio stable or increasing. If the ratio is decreasing, further investigation during the on-site |

| |analysis is warranted. |

| |Additional UBPR data, including: |

| |The bank's historic losses and recoveries (detailed at the top of page 7) Changes in the loan mix (page 7A). |

| |The level of non-current and past due loans and leases (page 8). |

| |During the on-site analysis, reassess any preliminary off-site analysis conclusions. For example, the ALLL may need to be adjusted due to |

| |adverse loan classifications, asset quality trends, and/or management's performance. |

| |Note: The LN&LS Allowance to LN&LS Not HFS ratio may be a more appropriate ratio to analyze if the institution has a significant volume of |

| |loans held for sale. This ratio represents the level of the ALLL against those loans not held for sale. The level and trend analysis |

| |considerations for this ratio are the same as for the LN&LS Allowance to Total LN&LS ratio discussed above. |

|Non-current LN & LS to Gross LN & LS |This ratio is one of the best indicators of asset quality problems in the UBPR. This ratio shows the percentage of the loan and lease portfolio |

| |that is non-current (i.e., loans that are past due 90 days or more and still accruing interest plus all loans in nonaccrual status). Consider |

|LN & LS past due at least 90 days |the: |

|+ LN & LS in nonaccrual status |Level. A lower ratio indicates that non-current loans are a small proportion of a bank's gross loans. A high ratio may indicate asset quality |

|Gross LN & LS |problems. Several things can influence this ratio. For example: |

| |If collection efforts are stepped up and the amount of delinquent loans is reduced, the ratio will decrease. |

| |If the loan volume increases, non-current loans and leases will become a smaller proportion of total loans, making this ratio smaller. However,|

| |it may not address the root cause of previously high levels of non-current loans (e.g., administration weaknesses may still be present). |

| |Trend. In general look for a decreasing or stable trend if the level is low. |

UBPR Page 7: Asset Quality Ratios

|Ratio and Calculation |Analysis |

|Recoveries to Prior Credit Loss Ratio |This ratio determines how recoveries in the current year compare with the prior year's recorded losses. Consider the: |

| |Level. A higher ratio is better because it indicates that the bank is improving its recovery efforts. How management addresses losses and how |

|Gross credit recoveries |much emphasis it puts on collection efforts will influence your analysis. For example, management can improve recoveries by employing: |

|in the current year (annualized) |A conservative charge-off policy, which means the bank charges off problem credits well before there is no possibility of recovering losses |

|Gross credit losses of the preceding year |(i.e., the bank is able to recover some of what it has booked as loss) |

| |Aggressive collection efforts. |

| |A low ratio may indicate that management has difficulty collecting problem credits or is delaying loss recognition. |

| |Trend. It is common for this ratio to be volatile. In addition, this ratio can be easily skewed for a number of reasons including a significant |

| |charge-off or recovery occurring in a prior period or a recovery occurring in the same period as the charge-off. Refer to the raw data at the |

| |top of the page for a more accurate perspective of distortions to this ratio (e.g., unusual charge-offs or recoveries in a given period). |

|Net Losses by Type of LN & LS Ratios |These ratios show the level of losses experienced within each specific loan type (e.g., real estate loans, construction and land development |

| |loans, 1-4 family mortgages). A negative value indicates a net recovery for that type. Analyze the: |

|The formula for each type is: | |

| |Level. In general, lower ratios are better because they indicate that losses for a particular type are a small proportion of average loans in |

|Year-to-date net |that type. A high level of losses within a particular loan type may indicate underwriting, collections, or asset quality problems for that type |

|LN & LS losses in the category |of lending. |

|Year-to-date average loans | |

|in the category |Trend. Increasing trends in any type indicate developing problems in that loan type. |

| | |

| |Keep in mind that you must factor in the bank's loan mix when analyzing individual loan types. For example, if loss levels appear high for a |

| |given type, consider whether that type represents a significant proportion of the bank's portfolio by reviewing the loan mix data on UBPR page |

| |7A. |

UBPR Pages 8 and 8A: Asset Quality Ratios

Pages 8 and 8A provide an analysis of past due, nonaccrual, and restructured loans and leases. Ratios on these pages provide data that feed into the past due ratio on page 1.

|UBPR Data |Analysis |

|The summary of non-current loans and leases at the|This section summarizes all loans and leases that are: |

|top of page 8 |Past due 90 days and over |

| |In non-accrual status |

| |Considered non-current (the sum of the above bullets) |

| |Past due 30-89 days. |

| |If you identify deteriorating trends in any of these categories, review the remaining sections of pages 8 and 8A to determine if past due loans |

| |are prevalent across all categories or isolated in one or a few categories. If there are no prevalent losses across these categories, further |

| |review of the ratios on pages 8 and 8A is generally not required |

|The percentage of non-current loans and leases by |These ratios provide information about the distribution of delinquent loans and leases. In each loan type, the following items are shown as a |

|loan type, shown on the remainder of page 8 and |percentage of the gross loan and lease balance for the type. For each loan and lease type, consider the: |

|page 8A. |Level. A lower ratio is better. If delinquency levels appear to be high for a given type, consider whether the type represents a significant |

| |proportion of the bank's loan portfolio. A high level of non-current and past due loans and leases within a type indicates potential |

|For each Loan and lease type, the formula for this|underwriting or asset quality problems |

|ratio is: |Trend. A decreasing trend is good. However, a dramatic decline between reporting periods may indicate significant asset quality improvement, |

| |liberal renewal policies, or inaccurate reporting by management. |

|Non-current LN & LS | |

|Gross LN & LS balance | |

UBPR Pages 8 and 8A: Asset Quality Ratios (continued)

|UBPR Data |Analysis |

|The percentage of non-current loans and leases by |In addition to reviewing each individual loan type, look across all types to determine if delinquent and nonaccrual loans are isolated in one or|

|loan type, continued |a few types or if they appear to be spread across all types. |

| |If delinquent and nonaccrual loans are widespread across many types, the bank may have a systemic problem in its lending practices. |

| |If delinquent and nonaccrual loans are isolated in one or a few types, there may be economic factors influencing the level of delinquent and |

| |nonaccrual loans in that type or asset quality problems may be limited to a particular lending department within the bank. |

ON-SITE ANALYSIS

Once the examination team has determined adverse classifications, three ratios will provide more information about the impact the adversely classified loans and other assets have on exposing the bank to risk. These ratios are also included on the Examination Data and Ratio page of the Report of Examination.

|Ratio and Calculation |Analysis |

|Adversely classified items coverage ratio |This ratio is a measure of the level of asset risk and the ability of capital to protect against that risk and is the most commonly referenced |

| |asset quality ratio. It reflects the aggregate level of all items classified as substandard, doubtful, and loss in relation to Tier 1 Capital |

|Adversely classified items |and the ALLL. |

|Tier 1 Capital + the ALLL |A lower ratio is desirable since a higher ratio indicates increased exposure to poor-quality assets and off-balance sheet items. A higher ratio|

| |may also indicate less ability to absorb the consequences of bad loans. |

|Total adversely classified assets to total assets |This ratio determines the aggregate level of all assets classified as substandard, doubtful, and loss in relation to total assets. |

|ratio |A lower ratio is desirable since a higher ratio indicates increased exposure to poor-quality assets. |

| | |

|Adversely classified assets | |

|Total assets as of the exam date | |

|Total adversely classified LN & LS to total LN & |This ratio determines the aggregate level of all loans and leases classified as substandard, doubtful, and loss in relation to total loans and |

|LS ratio |leases. A lower ratio is desirable since a higher ratio indicates increased exposure to poor-quality assets. |

| | |

|Adversely classified LN & LS | |

|Total LN & LS as of the exam date | |

Asset Quality Evaluation Factors and Rating Definitions

|Evaluation Factors |The UFIRS evaluation factors for asset quality include the: |

| |Adequacy of underwriting standards, the soundness of credit administration practices, and the appropriateness of risk identification programs |

| |Level, trend, distribution, and severity of identified and/or potentially problem on- and off-balance sheet items |

| |Adequacy of the ALLL and other valuation reserves |

| |Risk arising from unfunded commitments, credit derivatives, standby letters of credit, and lines of credit |

| |Diversification and quality of the loan and investment portfolios |

| |Risk arising from securities underwriting and trading activities |

| |Existence of asset concentrations |

| |Adequacy of the loan and investment policies and practices |

| |Ability of management to administer assets, including the timely identification and collection of problem assets |

| |Adequacy of internal controls and management information systems |

| |Volume and nature of credit documentation exceptions. |

|Rating Definitions |A rating of 1 indicates strong asset quality and credit administration practices. Identified weaknesses are minor in nature and risk exposure is modest in relation to capital|

| |protection and management’s abilities. Asset quality in such institutions is of minimal supervisory concern. |

| |A rating of 2 indicates satisfactory asset quality and credit administration practices. The level and severity of classifications and other weaknesses warrant a limited level|

| |of supervisory attention. Risk exposure is commensurate with capital. |

| |A rating of 3 is assigned when asset quality or credit administration practices are less than satisfactory. Trends may be stable or indicate deterioration in asset quality |

| |or an increase in risk exposure. The level and severity of classified assets, other weaknesses, and risks require an elevated level of supervisory concern. There is |

| |generally a need to improve credit administration and risk management practices. |

| |A rating of 4 is assigned to financial institutions with deficient asset quality or credit administration practices. The levels of risk and problem assets are significant, |

| |inadequately controlled, and subject the financial institution to potential losses that, if left unchecked, may threaten its viability. |

| |A rating of 5 represents critically deficient asset quality or credit administration practices that present an imminent threat to the institution’s viability. |

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