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Big Swing in ALLL? Check Your PPP Pool

It’s 5:01 p.m. You just finished your quarterly ALLL analysis and you’re ready to send the report up the chain before you head out for the weekend. 

But wait. Something’s off... Why did the bank’s surplus in loan loss reserves drop so much between Q1 and Q2?! 

Look at your PPP loans, says Jeff Schmid, FIPCO director – compliance and management services.

Schmid, along with other industry experts, advises banks to create a separate pool for loans made under the Paycheck Protection Program. PPP loans are zero risk weighted for capital requirements and carry a 100% guarantee from the U.S. Small Business Administration, so they should be grouped separately from the rest of the bank’s commercial and industrial (C&I) portfolio.

If PPP loans are not pooled separately, the allowance for loan and lease losses (ALLL) analysis will incorrectly apply the bank’s historical loss calculation. Since—for most institutions—PPP is where the majority of the past quarter’s loan growth came from, misapplying the historical loss calculation could cause a swing in the calculated reserve of $100,000 or more. 

Another reason to isolate PPP loans, even if the bank’s ALLL calculation doesn’t seem too far off from normal, is the upcoming forgiveness phase for the loans. If the bank has pooled PPP in with all other C&I loans, there is potential for PPP loans to (falsely) motivate the bank to increase provisions over the next half of the year. Then, as the loans are forgiven, the bank’s balances will drop, leaving it with a surplus of ALLL. 

In addition, Schmid advises bankers to be cognizant of the nine FAS 5 qualitative factors and adjust them at least every six months at a minimum. Especially given today’s economic environment factors, banks should consider increasing those percentages anywhere from 15 to 25 bps, especially on mortgages and commercial operating loans. However, banks should consider separating commercial real estate from commercial operating loans, if they don’t already do so. CRE loans have very different qualities, Schmid reminds. 

Another ALLL consideration is whether the bank has implemented CECL standards. The outsized impact of PPP loan pooling is especially significant to community banks that have not yet adopted CECL.

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Aside from PPP loan origination, banks should pay close attention to any charge-offs during the second quarter and the impact a large write-down may have on a small, homogeneous pool. If the bank can make the case to expand its historical loss from four or eight quarters to something longer, like 12 quarters, this may help equalize any anomalous transactions. It is essential to document this decision with the bank’s board of directors. 

Processing fees received from SBA for PPP loans weren’t in anyone’s 2020 budget—if they were in yours, please let me borrow your crystal ball... I have lotto tickets to buy!—which means any income generated from PPP should be accounted for separately from "normal” lending activity. 

Questions? Schmid and the FIPCO ShareFI team can be reached at jschmid@ficpo.com or 608-441-1220.