Under the banking agencies\' regulatory classification guidelines, \"Substandard
ID: 2376409 • Letter: U
Question
Under the banking agencies' regulatory classification guidelines, "Substandard" assets are defined as assets that are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. How should an allowance be established for a commercial loan adversely classified as "Substandard" based on this regulatory classification framework?
Explanation / Answer
Given the definition, a "Substandard" loan that is individually evaluated for impairment under FAS 114 (and that is not the remaining recorded investment in a loan that has been partially charged off) would not automatically meet the definition of impaired. However, if a "Substandard" loan is significantly past due or is in nonaccrual status, the borrower's performance and condition provide evidence that the loan is impaired, i.e., that it is probable that the institution will be unable to collect all amounts due according to the contractual terms of the loan agreement. An individually evaluated Substandard loan that is determined to be impaired must have its allowance measured in accordance with FAS 114.
For Substandard loans that are not determined to be impaired in accordance with FAS 114, experience has shown that there are probable incurred losses associated with a group of "Substandard" loans that must be provided for in the ALLL under FAS 5. Many institutions maintain records of their historical loss experience for loans that fall into the regulatory "Substandard" category. A group analysis based on historical experience, adjusted for qualitative or environmental factors, is useful for such credits.
For an institution whose groups of loans with similar risk characteristics include both loans classified "Substandard" (and not determined to be impaired) and loans that are not adversely classified, the institution should separately track and analyze the "Substandard" loans in the group. This analysis will aid in determining whether the volume and severity of these adversely classified loans differs from the volume and severity of such loans during the period over which
the institution's historical loss experience was developed and, if so, the extent and direction of a qualitative adjustment to the historical loss experience used to estimate the ALLL for the group of loans under FAS 5.
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