Credit Grading System Helps Analyze Loan Loss Reserve

In order to understand what credit/loan grading system is and how

and why it works, let us first understand what is loan loss reserve

and what is loan loss reserve methodology, how and why it

functions.

Loan Loss Reserve

Loan loss reserve also known as allowance for loan losses in

defined as a contra-asset account on a bank’s balance sheet which

is netted against gross loans. Usually, the level of loan loss reserve

rises each quarter by the amount of the loan loss provision. This

level gets reduces by the level of net charge-offs.

Calculation of Loan Loss Reserve

Essentially, the calculation of loan loss reserve is associated with

the bank’s attempt or its preparedness to cope up with the

insolvency. The figure calculated is basically a figure that shows

bank’s capacity to cover losses on its outstanding loans. Hence, it

can be either positive or negative.

If the loans go wrong, they are charged off and hence bank removes

them from their positive assert portfolio. The following action is the

subtraction of the loan’s book value from the loan loss reserve

account total. In case of collateralized loan, in order to replenish the

loan loss reserves, collateral is liquidated and deposited into the

loan loss reserve account.

Establishing Reserve Allocations

Having understood what loan reserves are and how they work, it is

quite a task for the institutions to set up an exact or appropriate

loan loss reserve. One has to be very discretionary and guided by

expert credit judgment. There are however, many professional

companies that provide such services and make it easier for the

banks.

Things to consider while setting up Reserve Allocations

The experts or the expert agency that undertake the task of setting

up adequate loan reserves must take into consideration bank’s

historical experience, current economic conditions and its

relationship with the customers. There is nothing wrong in applying

the regulatory guidance in the process, but it is advised to avoid

accounting approach. The main reason why accounting approach

should be avoided is because it inhibits bank management’s

expertise to determine loan loss reserve levels.

The purpose of any Credit Grading System

The most obvious purpose of setting up any such system or method

that sets up the loan reserves is that it has to be functional. Also,

the potential benefits should be far greater and deeper than the

costs of measurement. It is equally important that the results are

intelligible to all including stakeholders, management, regulators

and investors.

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