Year-end 2008 call report data confirms that delinquencies and charge-offs continue to rise throughout the credit union industry. For credit unions over $100 million in assets, the delinquency ratio stands at 1.3% as of year-end, and the charge-off ratio climbed to .9% for the full calendar year. While these results compare favorably to FDIC-insured institution rates of 2.9% and 1.3% respectively, many credit unions are facing their highest levels of loan impairment in recent history.
The call report data reflects that the Allowance for Loan Losses did increase throughout 2008 in response to increasing loss exposure. Unfortunately, delinquent loans rose at an even faster pace as noted in the chart below.
The rising levels of loan degradation should focus the attention of those charged with corporate governance on the adequacy of the Allowance for Loan Losses. Failure to recognize these increased losses vis-à-vis increased provision for loan loss expense could result in significant overstatement of earnings (and retained earnings), and raise the question of earnings management.
The objective of the Allowance for Loan Losses is to measure the amount of impairment in the portfolio as of the balance sheet date. Most credit unions have relied solely upon historical loss ratios to accomplish this objective in the past. However, since historical loss ratios are probably not reflective of current loss trends, their use alone will probably result in erroneous Allowance balances. The historical loss ratios must be supplemented with other tools, most notably the use of what are referred to as Qualitative and Environmental (Q&E) factors. Also, credit unions must have procedures in place to identify loans meeting the definition of troubled debt restructures, which can have a very material impact on the Allowance adequacy.
Here are some signs that might be indicative of a potential shortfall in your Allowance for Loan Losses:
- The balance of delinquent loans significantly exceeds the balance of the Allowance.
- The amount of net charge-offs for the past quarter, extrapolated to an annual amount, exceeds today’s balance of the Allowance.
- Your credit union has not analyzed impairment on real estate loans, even loans that are not yet delinquent. This is especially important for second trust deed loans, in geographic areas suffering large declines in market value.
- Your credit union is still using a 2-year or 3-year loss ratio.
- The rate of increase in loans delinquent less than two months is escalating, but your Allowance is only marginally adequate today.
Numerous parties throughout the organization have important roles in determining Allowance adequacy. Most notably, the CEO, CFO, CLO and the internal audit Director must understand Allowance theory, and be directly involved with oversight of the Allowance. Now is the time to ensure you have a proper understanding of these requirements, and have updated your Allowance policies and procedures to reflect the highly unusual economic cycle that we are currently experiencing.