The Art & Science of Provisioning for Impaired Assets

1. The Art & Science of Provisioning for Impaired Assets Dave Grace Managing Partner Dave Grace & Associates February2013

2. Is this an Asset?

3. Who is Dave?www.DaveGraceAssociates.com • 6 years central bank in USA • 13 years World Council of Credit Unions (WOCCU) • 18 months consultant IMF/WB • Worked in 60+ countries

4. Agenda • Impairment of Assets in Financial Institutions • Terminology • Determining when to create provisions for loans and investments • How to create provision and recognize collateral • Writing off assets • Recognition of Recoveries

5. IFRS 9 - Impairment of Financial Assets

6. IFRS 9 – Response to Provisioning process that didn’t work in Crisis • FASB and IFRS have had different approaches resulting in complex proposals. • Standard is taking a long time. • Core Issue: Likelihood of a loss event in the next 12 months -- forward looking provisioning.

7. Terminology • Impaired Asset = bad loan or investment. • Non-performing loan = delinquency. • Provisioning is an expense to the Income Statement. • Allowance for loan/investment loss is a cumulative account on the balance sheet. • Write off = Charge off.

8. Provisions & ALL • When is a loan delinquent? • What is the aging schedule? • Can collateral Values be counted? • How to determine collateral values?

9. When is a loan delinquent? • Current Regs: 91st day • PEARLS: 31st day

10. Aging Schedule

11. Can Collateral off set the required provision expense? Yes, if: • It’s a loan secured by land, building or new car loan. • CU will realistically repossess collateral in a timely manner & courts allow it. • The CU can sell the collateral. • CU has recent valuations of collateral meeting the following criteria. • If process too complex or CU does not have records to validate collateral values, then collateral CANNOT be used to off set the amount needed for provisions.

12. Valuing Criteria • Collateral independently appraised within last 2 years & appraisal shows at least two comparable sales to justify the value. • 2 years of data on showing actual forced sale prices for collateral types vs. appraised values. Determine haircut and apply this amount.

13. Example: • Mortgage is 8 months delinquent. Value of remaining loans is $220,000. Member has $500 is shavings & shares. Exposure to be provisioned is $110,000-$500 = $109,500 • Recent appraisal (including comparable sales) assesses value at $240,000. • Actual experience at this Financial Institution (FI)is that forced sales sell for 30% less than appraised value. • Exposure =$109,500 • Collateral value less 30% haircut =$168,000 (ie. $240,000*.70) • Amount to provision= $109,500 - $168,000= -$58,500 =$0

14. Near Real Life Example • A FI has a $465,000 loan for restaurant equipment that is 7 years past due. The restaurant has been vacant and vandalized for 7 years. Only collateral is a parcel that the FI does not have title to. • What should it do?

15. Writing off assets • You first need to make provisions to create the allowance for loan/investment loss. • Any loan or investment not performing for 12 months should be written off. • Example a FI that has not written off loans in 30 years. A FI that has never repossess as asset for a bad loan in 26 year history.

16. Recognition of Recoveries • Once a loan is written off any proceeds from additional collection activities should come into the income statement as recoveries, not into the allowance for loan loss.

17. Thank you. dgrace@DaveGraceAssociates.com www.DaveGraceAssociates.com