Huntington National Bank 2005 Annual Report Download - page 59

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MANAGEMENT’S DISCUSSION AND ANALYSIS HUNTINGTON BANCSHARES INCORPORATED
Allowances for Credit Losses (ACL)
(This section should be read in conjunction with Significant Factors 1, 3, and 4.)
We maintain two reserves, both of which are to absorb probable credit losses: the allowance for loan and lease losses (ALLL) and
the allowance for unfunded loan commitments and letters of credit (AULC). When summed together, these reserves constitute
the total ACL. Our credit administration group is responsible for developing the methodology and determining the adequacy of
the ACL.
The ALLL represents the estimate of probable losses inherent in the loan portfolio at the balance sheet date. Additions to the
ALLL result from recording provision expense for loan losses or recoveries, while reductions reflect charge-offs, net of recoveries,
or the sale of loans. The AULC is determined by applying the transaction reserve process to the unfunded portion of the
portfolio adjusted by an applicable funding percentage.
We have an established process to determine the adequacy of the ACL that relies on a number of analytical tools and
benchmarks. No single statistic or measurement, in itself, determines the adequacy of the allowance. For determination purposes,
the allowance is comprised of two components: the transaction reserve and the economic reserve. The continued use of
quantitative methodologies for the transaction reserve and the introduction of the quantitative methodology for the economic
component may have the impact of more period to period fluctuation in the absolute and relative level of the reserves.
Transaction Reserve
The transaction reserve component of the ACL includes both (a) an estimate of loss based on characteristics of each
commercial and consumer loan, lease, or loan commitment in the portfolio and (b) an estimate of loss based on an
impairment review of each loan greater than $500,000 that is considered to be impaired. The latter was formerly
referred to as the specific reserve.
For middle market commercial and industrial, middle market commercial real estate, and small business loans, the
estimate of loss is based on characteristics of each loan through the use of a standardized loan grading system, which is
applied on an individual loan level and updated on a continuous basis. The reserve factors applied to these portfolios
were developed based on internal credit migration models that track historical movements of loans between loan ratings
over time and a combination of long-term average loss experience of our own portfolio and external industry data.
In the case of more homogeneous portfolios, such as consumer loans and leases and residential mortgage loans, the
determination of the transaction reserve is conducted at an aggregate, or pooled, level. For such portfolios, the
development of the reserve factors includes the use of forecasting models to measure inherent loss in these portfolios.
We analyze each middle market commercial and industrial, middle market commercial real estate, or small business
loan over $500,000 for impairment when the loan is non-performing or has a grade of substandard or lower. The
impairment tests are done in accordance with applicable accounting standards and regulations. For loans that are
determined to be impaired, an estimate of loss is reserved for the amount of the impairment.
Models and analyses are updated frequently to capture the recent behavioral characteristics of the subject portfolios, as
well as any changes in the loss mitigation or credit origination strategies. Adjustments to the reserve factors are made as
needed based on observed results of the portfolio analytics.
Economic Reserve
Changes in the economic environment are a significant judgmental factor we consider in determining the appropriate
level of the ACL. The economic reserve incorporates our determination of the impact on the portfolio of risks
associated with the general economic environment. The economic reserve is designed to address economic uncertainties
and is determined based on a variety of economic factors that are correlated to the historical performance of the loan
portfolio. Because of this more quantitative approach to recognizing risks in the general economy, the economic reserve
may fluctuate from period-to-period.
In an effort to be as quantitative as possible in the ACL calculation, we implemented a revised methodology for
calculating the economic reserve portion of the ACL in 2004. The revised methodology is specifically tied to economic
indices that have a high correlation to our historic charge-off variability. The indices currently in the model consist of
the U.S. Index of Leading Economic Indicators, U.S. Profits Index, U.S. Unemployment Index, and the University of
Michigan Current Consumer Confidence Index. Beginning in 2004, the calculated economic reserve was determined
based upon the variability of credit losses over a credit cycle. The indices and time frame may be adjusted as actual
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