Bank Loan Criticism Grades and Reserve Treatment
Summary
The document explains how bank examiners classify loan quality, from Pass and Special Mention through Substandard, Doubtful, and Loss. Criticized loans are identified as those graded Special Mention, Substandard, or Doubtful. The grades distinguish emerging weaknesses from situations where repayment is increasingly uncertain or the loan is uncollectible.
Banks generally establish reserves for criticized loans to reflect that they may be worth less than their stated value, with an effect on both the income statement and balance sheet. The document describes exceptions in which a criticized loan may not need a separate reserve, such as when it is already being sold, is carried at fair value, or falls under another special circumstance. This is a brief, general explanation rather than detailed regulatory guidance; it does not specify how reserves are calculated or address differences across accounting rules and supervisory contexts.
Key ideas
- Loan examiners assign grades that reflect the borrower's condition and the likelihood of repayment.
- Special Mention, Substandard, and Doubtful loans collectively make up criticized loans.
- Banks generally reserve against criticized loans to recognize potential losses.
- A pending sale or fair value accounting may already account for a loan's reduced value.
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Full text
# What is non-reservable criticized exposure? # What is non-reservable criticized exposure? I'm new to credit risk. I wanted to know what is the meaning of reservable/non-reservable criticized exposure? Can someone please help. ## Answer by Alex C (score 0, accepted) https://quant.stackexchange.com/a/32332 When regulators (such as the FDIC) examine a Bank, they look at the quality of a sample of loans (assets) and assign each a "grade" (to use a term used in schools) or classification as follows: Pass - Everything OK with this loan. No need to do anything. Special Mention - Everything OK for now but we have some concern about weaknesses that could cause problems in the future. Management should keep an eye on this loan and we may need to review it again in the future. Substandard - some problems apparent. There is a "distinct possibility" that the bank may sustain some loss on this loan. Doubtful- problems and facts sufficient to make the full recovery of this loan "highly questionable and improbable" Loss - this loan is uncollectable and does not belong on the balance sheet of a Bank. This loan must be written off immediately (although you may make efforts afterwards to sell it to recover what little value if any it has left if you wish). As my colleague pointed out above, "criticized" loans are the union of: Special Mention, Substandard, and Doubtful. What must the Bank do about "criticized" loans? Generally they will need to set up a reserve to allow for the fact that this loan is no longer worth 100 cents on the dollar. This will hit the income statement and the balance sheet. These are the "reserveable criticized loans". However there are some legitimate reasons why some of these loans may not need to go through this. Good and sufficient reasons to make a loan a "non-reservable criticized" loan include: - The loan is already in the process of being sold - The loan is accounted for under the "fair value" method which already takes onto account its problems - Some other special situations
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