Loan loss reserve stands for the contra-asset account on a financial institution’s balance sheet which is netted against gross loans. The loan loss reserve is incremented by the value of loan loss provision in every quarter and decremented by the quantity of net charge-offs.

1. Top insights into the loan loss reserve
methodology of banks

2. Loan loss reserve stands for the contra-asset account on a financial institution’s
balance sheet which is netted against gross loans. The loan loss reserve is
incremented by the value of loan loss provision in every quarter and decremented
by the quantity of net charge-offs.
Need for loan loss reserve validation
The LLR Methodology is subjected to review to ascertain its compliance to
regulatory guidelines, rationality in determining the reserve allocations and ensure
reflection of the same through proper statement in the financial institution’s loan
policy.
Determining loan loss reserve
The adjustment of bank’s loan loss reserve is carried out every quarter contingent
on the projected interest loss in the institution’s net loan portfolio inclusive of
performing and nonperforming ones.

3. Loan Loss Reserve Methodology may vary from bank to bank, but the loan loss
reserve pertaining to lesser balance homogenous loans are typically ascertained
by factoring in groups of similar loan types that share similar credit attributes.
Various analytical models are embraced which investigates in depth the
contributing factors, primarily the projected loss severities, experienced loss
frequencies and historical delinquency terms. The reserves for loans take into
account the portfolio’s inherent losses which are projected to be discerned in the
12 months to follow.
Credits in loan loss reserve validation which emerges with a rating of 1 to 11
are declared ‘pass’, credits with rating 12 are assigned ‘pass watch’, 13 gets
‘special mention’, 14 is ‘substandard’, 15 becomes ‘doubtful’, and 16 is ‘loss’.
The total of 13, 14, 15 and 16 are collectively defined as ‘criticized’ loans.
Further, loan classification also takes place under the header of FAS 114
impaired loans. Loss reserves are then finally established in consideration of the
loan type and grade, migration trends and severity of loss. The experience that
took place most recently is assigned most weight.

4. A third party reviewer conducts analyzing, testing and validation of the
methodology that underlies the general and specific loan allocations. The
portfolio experience of the past 3 to 10 years are taken into consideration which
involves study of loan grades migration, robustness of the loan grading system,
alterations in portfolio mix, and loss experience.
Further, portfolio risks trends are also analyzed in consideration of the
concentrations like loan and collateral types, large loan exposures, loan policy
maintenance, and industry and loan grades. Other factors that are pertinent to the
portfolio profile such as off balance sheet commitments, delinquency and nonaccrual trends and peers loss experience are also factored in. The observations
and conclusions provide valuable insights to fortify the loan loss reserve
validation and increase timely loan recovery.

5. Loan Loss Reserve Methodology and Validation (LLR Methodology) by CEIS Review
http://www.ceisreview.com/pages/Services/2/149/Methodology_Validation
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