Internal Audit and the ALLL Estimate Risk

June 2017

Internal Audit and the ALLL Estimate Capitalize on Internal Audit’s Potential in Allowance Reviews

An article by Jaideep Chadha, CIA; Jim Romask, CPA; and Justin Van Beek, CPA

Audit / Tax / Advisory / Risk / Performance

Smart decisions. Lasting value.™

Internal Audit and the ALLL Estimate

The allowance for loan and lease losses (ALLL) estimate incurs a high level of scrutiny, audit, and review from both internal and external stakeholders. The frequency and intensity of the scrutiny applied to the allowance by many stakeholders may lead internal audit functions to reduce their scoping or testing efforts surrounding this estimate, simply to avoid duplication of resources and related internal criticism of redundancies with other internal or external parties.

However, while reliance on other allowance reviews may appear practical, particularly given the focus on efficiency in today’s internal audit environment, diminished internal audit involvement in examining the allowance may not be prudent.

The unique organizational position of internal audit provides valuable insight into cross-functional activities and risks accompanying the allowance.

Internal audit’s active role and involvement in evaluating the allowance adds critical value in meeting current and soon-to-be-expanded reporting requirements and satisfying the concerns of allowance stakeholders.

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Internal Audit’s Unique Position Allowance reviews performed outside of internal audit’s purview typically concentrate on a single objective, such as providing assurance of a materially correct financial statement estimate, or demonstrating compliance with a specific facet of regulatory guidance. Such targeted efforts might fail to examine the allowance estimate from beginning to end in a manner that considers cross-functional stakeholders and related processes. Producing an assessment of the effectiveness of management’s allowance process based on separately executed reviews might not provide a comprehensive assessment nor highlight potential interrelated benefits or risks. Further, separate reviews often do not specifically identify what is – and is not – in scope, which increases the difficulty in assessing comprehensiveness.

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Internal audit functions are unique because they have the potential to consider a broad array of risks faced across the entire organization. This capability enables internal audit to provide a holistic assessment of the allowance, which considers risks in an interconnected and integrated manner.

Internal audit is also in a unique position when it comes to implementing the new current expected credit loss (CECL) standard. As organizations devote significant time and resources to adopt this challenging new allowance standard, internal audit’s early and frequent involvement during implementation might reveal new efficiencies and value.

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Internal Audit and the ALLL Estimate

Use Internal Audit to Avoid Common Allowance Criticisms Given the value that internal audit provides related to the allowance, consider the following factors when planning an allowance evaluation:

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Environmental and qualitative factors.

Comprehensive documentation supporting the allowance facilitates an effective and efficient review of the ALLL estimate.

The Interagency Policy Statement on the Allowance for Loan and Lease Losses indicates that estimated credit losses should reflect consideration of “all significant factors that affect the collectability of the portfolio as of the evaluation date.”1 These factors include both historical loss rates and “qualitative or environmental factors that are likely to cause estimated credit losses associated with the institution’s existing portfolio to differ from historical loss experience” – including the nine “environmental,” or “qualitative,” factors.2 The very nature of these environmental or qualitative factors introduces a healthy level of judgment and subjectivity that cause challenges related to the factors’ precision and sufficiency of documentation. For example, accurate documentation demonstrating a measurable level of precision in the movement of qualitative factors applied to “changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses” may pose challenges.3 Internal audit’s understanding of and experience with underwriting trends or credit administration audit results may prove beneficial for management’s consideration when addressing these qualitative factors.

Directional consistency. Qualitative factors require a significant level of managerial judgment. Challenges abound for management to support the directional consistency of adjustments. For example, economic indicators have generally improved over the past several years. However, organizations may experience situations in which the qualitative factors tied to these economic indicators have not adjusted in a commensurate manner as compared to the targeted economic indicator. Frequent internal audit testing can help identify the lack of directional consistency between the allowance estimates and underlying indicators to provide management sufficient time to correct the situation proactively, prior to stakeholder criticism.

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Loan grading. While credit administration is commonly charged with loan grading and/or identification of credit deterioration, the interagency policy statement on the allowance indicates that the loan grades should be subject to an independent review.4 Occasionally, the scope of loan review might deviate from an approved plan, resulting in the misalignment of loan review coverage.

Internal audit provides value by assessing the frequency and scope of loan grading along with comment on the adequacy of this independent review to ensure compliance with regulatory guidance. Further, internal audit’s observations regarding operational deficiencies applicable to a particular lending portfolio can result in suggestions to increase that particular loan portfolio’s review scope and coverage.

Model validation. The Supervisory Guidance on Model Risk Management (SR Letter 11-7) requires models to be periodically validated to confirm that they are performing as expected and according to their design objectives and business uses.5 An ALLL calculation is commonly identified as a model and subject to validation expectations. SR Letter 11-7 notes, “As with other aspects of effective challenge, model validation should be performed by staff with appropriate incentives, competence, and influence.” Moreover, “validation involves a degree of independence from model development and use.”6 When an organization does not maintain a formalized model risk management function, internal audit can play a role in establishing the validation requirements and procurement of an independent party to conduct the exercise. Additionally, within a model validation, opportunities might exist to take advantage of the work already performed by internal audit, such as data validation to the general ledger, resulting in efficiency and cost savings.

Calculation and estimate ownership. An allowance policy should clearly establish who is responsible for oversight of the distinct components (commonly separated to align to ASC 310 and ASC 450 GAAP guidance) that support the allowance estimate. The policy should define the reporting roles and responsibilities of key departments such as lending, accounting, finance, and special assets.

From time to time, departments might

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fail to communicate in a timely manner or share pertinent information relevant to the allowance estimation. For example, if a lending department receives a recent real estate appraisal related to a classified loan with a significant decline in value from prior recorded values after quarter-end, and such information is not relayed to the financial reporting function, this situation may result in allowance estimate error. Internal audit’s span across the organization can help identify and resolve these potential gaps.

Data controls. The allowance process is heavily dependent upon data and relies on many calculations. This dependence creates a high level of reliance on software and technology platforms. The estimation process often relies on custom reports and queries that support qualitative and quantitative factors. For many organizations, spreadsheets accumulate the data from these reports and, through numerous and occasionally complex formulas, establish the allowance estimation. Operational and data controls take on added importance, especially as stakeholder scrutiny intensifies under the new CECL standard. The vigilance of internal audit in evaluating internal controls on the completeness and accuracy of information used in the allowance calculation is critical. Additionally, internal audit procedures designed to address data consistency, security measures, and change control monitoring take on added importance for the internal auditor. These considerations can reduce thorny stakeholder questions in advance of potential problems.

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Fare Better by Utilizing Internal Audit Because it reaches across an organization, internal audit offers a wealth of insight in evaluating the allowance. If the internal audit function limits its review to narrowly scripted procedures (due to other coverage), an organization might lose an excellent opportunity to capitalize on the insight provided by internal audit. Further, changes on the horizon related to CECL present significant opportunities for the internal audit function to help organizations assuage stakeholder concerns. In short, financial institutions fare far better with various stakeholders, regulators, and external auditors when internal audit elevates above the routine review of controls or mechanics surrounding the allowance. When internal audit performs its own robust, cross-functional assessment of the allowance, potential allowance criticisms can be diminished, and organizations can gain valuable insights and implement new efficiencies.

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Learn More Jaideep Chadha +1 415 230 4966 jaideep.chadha@crowehorwath.com

Justin Van Beek +1 214 777 5267 justin.vanbeek@crowehorwath.com

Jim Romask Partner +1 216 623 7547 jim.romask@crowehorwath.com

1

“Interagency Policy Statement on the Allowance for Loan and Lease Losses,” Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, and Office of Thrift Supervision, 2006, p. 4, https://www.federalreserve.gov/boarddocs/srletters/2006/ SR0617a1.pdf

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Ibid, p. 8.

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Ibid.

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Ibid, p. 17.

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SR 11-7,“Supervisory Guidance on Model Risk Management,” Board of Governors of the Federal Reserve System and Office of the Comptroller of the Currency, April. 4, 2011, pp. 5, 9, 10, https://www.federalreserve.gov/bankinforeg/ srletters/sr1107.htm

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Ibid, p. 9.

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