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
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.
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

2. 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.
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

3. 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 non-accrual 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.
Loan Loss Reserve Methodology and Validation (LLR
Methodology) by CEIS Review -
http://www.ceisreview.com/pages/Services/2/149/Methodo
logy_Validation
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