Another expense that the bank management always must estimate care-
fully and take into consideration is to allow for any loan (credit) losses. This
expense is called the allowance for loan and lease losses (ALLL). The ALLL
is planned for by allocating an expense to allow for these potential losses.
This expense is like an emergency fund that can be tapped in case there is a
nonperforming loan. The money charged to the profit of the bank is consid-
ered as an asset. If a loan fails and is considered a loss, that will produce a
very serious expense item that can be detrimental to the bank. The first step
is for management to try to pay for the loss from ALLL. However, if ALLL
is not enough, then the amount is charged to the expenses, and if there is a
loss, this loss is charged to reduce the bank’s capital.
As an example, consider a situation in which the bank assets are $100
million, and out of these assets was a loan portfolio of $85 million. One of
the loans, say in the amount of $5 million, does not perform as agreed,
which means that the customer, for one reason or another, has not made
payments, cannot honor the loan commitment anymore, and is bankrupt.
The bank decides to expense this loan as a nonperforming loan. Suppose the
ALLL was $2 million. The bank management may try to allocate it to ALLL
and according to the rules they only can allocate $500,000. This reduces
ALLL to $1.5 million. Assets would be reduced by $5 million—$500,000
from ALLL and $4.5 million is allocated to reduction in income. If net
income was $4.5 million and the bank capital was $10 million, then the new
reduced bank capital would be $5.5 million. This may result in a bank with
inadequate capital ratios as required by the regulators. The bank is required
by the regulators to raise more capital in order to continue its operations.
Another unfortunate situation may happen. If the economy goes bad, or
if the loan department was sloppy and not careful about its credit analysis
and financing discipline, the bank might have four loans (say, $5 million
each) that are considered a loss. That would mean a loss of $20 million.
The net result would be that the bank capital is wiped out. Of course, bank
management can hide these losses in many ways. One of these ways is to
keep renewing these loans and not recognizing the facts, but in the end such
losses will have to be recognized. That is essentially what happened in 2008.
THE NEED FOR A GOOD DETAIL-ORIENTED
MANAGEMENT TEAM AT THE RF BANK
The success of any bank depends mostly on its management. Some bankers
may want you to believe that banking is a very sophisticated business. It
really is not. It is a simple business, but it requires intensive and expert
Operating an RF Bank in the United States 341