AUDITING YOUR ALLOWANCE FOR LOAN LOSSES Presentation to the AIBA on September 19, 2013

1. AUDITING YOUR ALLOWANCE FOR LOAN LOSSESPresentation to the AIBA on September 19, 2013 Chris B. Harris Managing Director ICS Consulting Partners

2. Outline of Presentation • Interagency Policy on ALLL • Audit Program Objective • Best practice ALLL audit program • Key documents to be aware of • Reviewing a loan file to determine ALLL • Root causes of errors in ALLL Process • WAR Stories • References to follow for ALLL • Sample Audit Findings • ALLL Policy/Methodology for determining ALLL

3. Interagency Policy /Allowance for Loan Losses“The ALLL represents one of the most significant estimates in an institution’s financial statements and regulatory reports. Because of its significance, each institution has a responsibility for developing, maintaining, and documenting a comprehensive, systematic, and consistently applied process for determining the amounts of the ALLL and the loan loss provision. To fulfill this responsibility, each institution should ensure controls are in place to consistently determine the ALLL in accordance with GAAP, the institution’s stated policies and procedures, management’s best judgment and relevant supervisory guidance.”

4. Audit Program ObjectiveTo perform an audit of the Allowance for Loan and Lease Losses to ensure the adequacy and effectiveness of the internal controls in accordance with GAAP and regulatory guidelines and the Bank’s policies.

5. Best Practice ALLL Audit Program • Part 1 - Determine adequacy of Policies and Procedures • Evaluate Policies and Procedures to determine whether they provide the basis for an effective internal control system over the function and to determine if management, consistent with its duties and responsibilities, has established procedures for governing the ALLL. • Does the Bank have adequate data capture and reporting systems to supply the information necessary to support and document its estimate of an appropriate ALLL? • Prior history of charge-offs and reserves. • Loan reviews • Appraisals • Minutes • Supervisory Loan to Value Report • Does the Bank periodically validate the ALLL methodology?

6. Best Practice ALLL Audit Program • Part Two - Determine the adequacy of your ALLL’s Control Environment • Is there adequate oversight by the Board of Directors of management’s judgments and estimates used in determining the ALLL? • Are the ALLL policies and procedures reviewed as least annually for: • Discussions relating to the Bank’s quantity of risk, risk management, and responsiveness to internal and external factors affecting the level of credit risk. • Reviewing management’s loan review system to ensure that it will identify, monitor, and address asset quality problems in an accurate and timely manner. • Reviewing management’s assessment and justification for the amounts estimated and reported each period for the Provision for Loan and Lease Losses and ALLL. • Reviewing management’s procedures to periodically validate, and when appropriate, revise the ALLL methodology.

7. Best Practice ALLL Audit Program • Part Two - Determine the adequacy of your ALLL’s Control Environment • Assess if there is an effective allowance evaluation process by: • Obtaining a description of the process used by management to determine if an appropriate level of the allowance has been recorded along with the supporting documentation for the most recent evaluation. • Review and perform the following to determine if the process is sound, based on reliable information, and well documented. • Review the written description of the process and methodology used by management to determine the adequacy of the allowance. • Review management’sassumptions, valuations and judgments for reasonableness and ascertain all information is properly supported and documented. • Determine whether managementhas considered historical loss experience for each group of loans with similar characteristics as well as qualitative and environmental factors that are likely

8. Best Practice ALLL Audit Program • Part Two - Determine the adequacy of your ALLL’s Control Environment • to cause estimated credit losses to differ from historical loss experience (examples are included in the Interagency Statement) • Determine whether management has implemented ASC #450 (FASB 105) for when measuring estimated credit losses for groups of loans with similar characteristics. • Determine whether management has implemented ASC #310 (FASB 114) for individually impaired loans. An “Impaired Loan” is a loan where, in management’s opinion, there has been a deterioration of credit quality to the extent that the Bank no longer has reasonable assurance as to the timely collection of the full amount of principal and interest.

9. Best Practice ALLL Audit Program • Part Two - Determine the adequacy of your ALLL’s Control Environment • Determine the rationale of the ALLL methodology that is used for determining the amount of loan loss provision. Determine that the methodology considers all key factors, including loan review ratings and past due status. • Determine whether the Bank performs a peer group (Uniform Bank Performance Report) analysis of other banks of its size and complexity. Determine if processes relating to loan charge-offs are adequate. • Ensure the accuracy of subsidiary records, security of notes, appropriate review and approval, and effective collection efforts.

10. Part Three - Other Testing Considerations • Evaluate the timeliness and effectiveness of corrective action taken by Management in response to prior regulatory reports of examination; internal/external audits; and, and loan reviews. • Determine the adequacy of loan review process; review prior reports and evaluate findings pertaining to “Downgrades.” • Determine if there is a process in place to include the most recent loan review write-up in the loan file. • Determine if there is a process in place to ensure that ratings downgrades noted in recent loan reviews and/or regulatory examinations are input into the accounting system as revise ratings may impact the ALLL calculation. • Is there a report of disagreements between loan review and management of loan ratings?

11. Appendix 1 - Key Documents To Be Aware Of • Formal Agreements and/or Matters Requiring Attention. • Credit Risk Management Strategy. • Credit Risk Dashboard from their ERM Program. • Minutes/documentation from Troubled/Restructured/Non-performing Loan Committee. • Impaired Loans that are Collateral Dependent. • Regulatory examination reports and resulting mandates. • Results of stress testing the portfolio. • Listing of Troubled Debt Restructures and the accounting treatment for activity. • Loan Underwriting Exception Report of Missing Documents. • Loan Review Reports including downgrades/document exceptions. • Results of Global Cash Flow Analysis.

12. Appendix 2 – How you review a file and determine reserve coverage. • Select a file on a regularly scheduled basis. • Determine if loan is current or delinquent • Determine whether financial statements and appraisals are up to date. • Evaluate/determine cash flow from financials. • Determine market value of collateral. • Determine if impaired; an “Impaired Loan” is a loan where, in management’s opinion, there has been a deterioration of credit quality to the extent that the Bank no longer has reasonable assurance as to the timely collection of the full amount of principal and interest. • Determine if Troubled Debt Restructure; process by which an institutional lender (such as a bank) modifies or relaxes the terms of a loan agreement to minimize the eventual loss by accommodating a borrower who is financially incapable of meeting them. • Determine exposure to the Bank.

13. Appendix 3 - Root Causes of Errors in the ALLL Process • ALLL policy and procedures that are not in compliance with the Interagency Policy Statement and updates to regulatory guidelines. • Definitions of Pass; Watch List; Substandard; and, Doubtful loan grades are not in compliance with best practice guidelines. • Failure to document the information sources (i.e. past due history; charge-off history; economic outlook) used for inherent risk factors; especially the ASC #350 allocation. • Failure to update inherent risk factors with more current information on a regular basis (i.e. quarterly; annually; “rolling” process). • Infrequent schedule of performing loan reviews. • Poor communication between lending officers and loan reviewer upon discovery of significant events. • Internal reviewers who are not independent of the loan origination process. Loan Originators should not be reviewing loans subsequent to funding. • Funding the ALLL provision without proper substantiation as to the rationale for the amount and properly allocating provisions to specific loans.

14. Appendix 4 – “War Stories” • Collapse of the commercial and residential real estate markets. • Cash flow not adequate to service debt. • Inadequate provisions allocated to the allowance for loan losses. • Loan reviews are contrary to loan officer’s outlook. • Unperfected liens. • Improper valuations of real estate collateral.

15. Appendix 5 - References to ALLL • 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses • 2012 Interagency Supervisory Guidance on Allowance for Loan and Lease Losses Estimation Practices for Loans and Lines of Credit Secured by Junior Liens on 1-4 Family Residential Properties • ASC #450 (FASB #5) - Accounting for Contingencies • ASC #310 (FASB #114) – Accounting by Creditors for Impairment of a Loan • FRB Commercial Bank Examination Manual - Section 2040 - Loan Portfolio Management) • FRB Examination Manual for U.S. Branches and Agencies of Foreign Banking Organizations - Section 6010 - Asset Quality Classifications • 2005 Statement of Position No. 03-3 - AICPA Statement of Position 03-3 - Accounting for Certain Loans or Debt Securities Acquired in a Transfer • 1995 Interagency Guidelines Establishing Standards for Safety and Soundness

16. Appendix 6 – Sample Audit Findings • The Credit Administration, Internal Asset Review, and, Classification policies should describe the process used in the calculation and include additional factors and details related to the ALLL process. • Ensure the Credit Administration and Internal Asset Review and Classification Policy is reviewed and approved by the Board on an annual basis. • ALLL memorandum provided to the Board of Directors should comply with regulatory guidelines. • The Quarterly ALLL memorandum should discuss differences between the calculated amount and that which is reported in financial statements. • Management should ensure that the Loan Quality Rating downgrades are adequately documented.

17. Appendix 7 – ALLL Policy - Methodology For Determining Allowance For Loan Losses • ALLOWANCE FOR LOAN LOSS (ALLL) COMMITTEE • The ALLL Committee consists of the President, CCO, CLO, CRO, CFO, Loan Workout Department Head and the Chairman of the Board. The Committee meets quarterly to review the adequacy of the ALLL and methodologies utilized in compiling data from internal reports noted below. • The data is reviewed and summary reports are prepared by the Workout Department to properly reflect adjustments in the ALLL report, including appropriate adjustments to risk ratings and reserve allocations as required. The CFO working with the CCO prepares a quarterly ALLL report/memorandum that complies with certain regulatory and accounting guidelines. This report/

18. memorandum is presented to and approved by the ALLL Committee and Board of Directors each quarter prior to release of operating results. • ALLL METHODOLOGY • The Board is responsible for the following in connection with the ALLL: • Reviews support for qualitative factors used in the ALLL analysis and ensure that the directional movement of the allocation for each factor is clearly supported. • Ensures the rationale is appropriately supported and consistently applied for historical loss rates developed. • Reviews updated evaluations and appraisals for impaired loans are documented. • Requires periodic independent validation of the Bank’s ALLL methodology and ensure that the methodology is revised when appropriate.

19. Reviews the Allowance calculation at least once each calendar quarter. Any deficiency in the ALLL shall be remedied in the quarter it is discovered by additional provisions for loan losses. Written documentation shall be maintained indicating the factors considered and conclusions reached by the Board in determining the adequacy of the Allowance. • A loan is impaired when, based on current information and events, it is probable that an institution will be unable to collect all amounts due according to the original contractual terms of the loan agreement. The Bank has determined that all troubled debt restructured loans (“TDRs”) and all Non-Accrual loans are impaired; however, Non-Accrual loans with an impaired balance of $250,000 or less will be evaluated under ASC 450 (formerly known as FAS 5) with other groups of smaller or homogeneous loans with similar risk characteristics. The Bank will use judgment to determine if there are other loans outside of these two categories that fit the definition of impaired. For example, accruing

20. Substandard loans (risk rated 6) may be considered impaired based upon recent delinquency or other factors that may put ongoing payments at risk. • ASC 310 (formerly FAS 114) • If a loan is considered impaired as defined above and is a 1) TDR, 2) non-accrual loan with an impaired balance of more than $250,000 or 3) an accruing Substandard loan considered impaired and with an impaired balance of more than $250,000, the Commercial Loan Workout Department will complete a ASC 310 (FAS 114) impairment analysis quarterly. Other loans to the same borrower that are collateralized by the same collateral pool will be included to determine if the $250,000 threshold has been reached. If the threshold is reached, the loan (s) will be included in the ASC 310 pool. • One of three measurement methods will be used to calculate the amount of the impairment:

21. 1) Present value of expected future cash flows (discounted cash flow analysis), • 2) Fair value of collateral less costs to sell or • 3) Observable market price of loans. • The present value of expected future cash flows method will generally be used unless: • 1) Repayment of the loan is expected to be provided solely by the underlying collateral and there are no other available and reliable sources of repayment and/or • 2) The loan is more than 60 days past due or has matured and it is unlikely that the borrower will bring the loan current and/or an extension will be negotiated and closed (i.e. there is no payment stream to calculate the present value) or • 3) There is an observable market price for the loan. Adjustments for environmental or qualitative factors may be included.

22. If there is no additional reserve or charge-off indicated, then the loan does not need to be reserved under either ASC 310 or ASC 450 (loans that do not need an additional reserve or charge-off will remain in the ASC 310 (FAS 114) pool and do not get transferred to ASC 450 (FAS 5 pool). For a loan that is impaired, no additional loss recognition is appropriate under ASC 450 even if the measurement of impairment under ASC 310 results in no allowance. • The Commercial Loan Workout Department maintains the supporting documentation regarding the discounted cash flow analyses and/or collateral valuations. Loans less than or equal to $250,000 will typically have less supporting documentation as the loans are pooled and allocated a reserve under ASC 450 (FAS 5). • The ASC 310 (FAS 114) calculation will determine the realizable value of the assets securing the impaired loan. Adjustments for cost to sell for impaired collateral dependent loans to determine the net collateral value are as follows:

23. For “arms-length” sales by borrower (property not in foreclosure), 5% brokerage fee for properties valued greater than $1,000,000 and 6% for properties valued less than or equal to $1,000,000, greater of $4,000 or 0.6% property value for legal fees and amount of delinquent real estate taxes (if any) are currently being used for properties where ties collateralizing loans are currently located. Updates will be obtained periodically from real estate brokers and law firms to determine if these percentages/dollar amounts are appropriate and for unique properties/situations where another percentage/dollar amount may be appropriate. • For properties in foreclosure, 5% brokerage fee for properties valued greater than $1,000,000 and 6% for properties valued less than or equal to $1,000,000, greater of $10,000 or 1.5% of property value for legal fees, amount of delinquent real estate taxes (if any), real estate taxes and insurance for two years or estimated time to complete foreclosure and repairs and maintenance equal to double the amount in appraisal for two years or estimated time to complete foreclosure.

24. As above, updates from real estate brokers and attorneys will be obtained on a periodic basis. • Will contact real estate brokers and law firms as needed to make sure that these costs to sell are still in line with market conditions. • ASC 450 (formerly FAS 5) • Loans which are not impaired will fall into an ASC 450 (FAS 5) pool reserve, for groups of smaller or homogeneous loans. • ASC 450 (FAS 5) loss estimates will be based upon past loss history and other environmental or qualitative factors. • Reserves should not be layered for double counted; therefore, loans should either be tested with ASC 310 (FAS 114) or ASC 450 (FAS 5) but not both.

25. The Comptrollers Department is responsible for the preparation of the monthly ALLL analysis. The data is compiled from the spreadsheet(s) received from the Workout Department and updated at quarter end to take into account loan payments. As noted above, the CFO working with the COO compiles a quarterly ALLL report/memorandum. The ALLL report is reviewed quarterly by the ALLL Committee and by the Board of Directors.

26. The ICS Consulting Partners team thanks you for attending this presentation. Questions/comments are welcome at this time. Contact Information Chris B. Harris Managing Director Telephone - 609-605-6392 E-mail - CHarris@ICSconsultingpartners.com Robin Ramistella Director Telephone - 862-221-8342 E-mail - RRamistella@ICSconsultingpartners.com