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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. Find more information at or call us on 888967-7380

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