TD Bank 2002 Annual Report Download - page 51

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FINANCIAL RESULTS
(h) Allowance for credit losses
An allowance is maintained which is considered adequate to
absorb all credit-related losses in a portfolio of items which are
both on and off the consolidated balance sheet. Assets in the
portfolio which are included in the consolidated balance sheet
are deposits with banks, loans, mortgages, loan substitutes,
securities purchased under resale agreements, acceptances and
derivative financial instruments. Items not included in the
consolidated balance sheet and referred to as off-balance sheet
items include guarantees and letters of credit. The allowance is
deducted from the applicable asset in the consolidated balance
sheet except for acceptances and off-balance sheet items. The
allowance for acceptances and for off-balance sheet items is
included in other liabilities.
The allowance consists of specific, general and sectoral
allowances.
Specific allowances include all the accumulated provisions
for losses on particular assets required to reduce the book values
to estimated realizable amounts in the ordinary course of busi-
ness. Specific provisions are established on an individual facility
basis to recognize credit losses on business and government
loans. For personal loans, excluding credit cards, specific provi-
sions are calculated using a formula method taking into account
recent loss experience. No specific provisions for credit cards
are recorded and balances are written off when payments are
180 days in arrears.
General allowances include all the accumulated provisions for
losses which are prudential in nature and cannot be determined
on an item-by-item or group basis. The level of the general
allowance depends upon an assessment of business and eco-
nomic conditions, historical and expected loss experience, loan
portfolio composition and other relevant indicators.
When an industry sector or geographic region experiences
specific adverse events or changes in economic condition, it may
be necessary to establish an additional allowance for loan loss for
the group of loans as a whole even though the individual loans
comprising the group are still performing. These allowances are
considered sectoral and are established for losses which have
not been specifically identified, and where the losses are not
adequately covered by the general allowances noted above. The
amount of the allowance is reviewed and adjusted regularly and
depends on management’s assessment of the current and expect-
ed business and economic conditions as well as the extent of the
Bank’s exposure to the sector.
General and sectoral allowances are computed using credit
risk models developed by the Bank. The level of the allowances
considers the probability of default (loss frequency), the loss
given default (loss severity) and the expected exposure at default.
The total level of allowances is considered adequate to absorb
all credit losses in the portfolio of on and off-balance sheet
items. Actual write-offs, net of recoveries, are deducted from
the allowance for credit losses. The provision for credit losses,
which is charged to the consolidated statement of operations, is
that required to bring the total of all allowances (specific, general
and sectoral) to a level which management considers adequate
to absorb probable credit-related losses in its portfolio of on and
off-balance sheet items.
(i) Loan securitizations
When loan receivables are sold in a securitization to a qualifying
special purpose entity under terms that transfer control to third
parties, the transaction is recognized as a sale and the related
loan assets are removed from the consolidated balance sheet. As
part of the securitization, certain financial assets are retained and
consist of one or more subordinated tranches, servicing rights,
and in some cases a cash reserve account. The retained interests
are classified as investment account securities and are carried at
cost or amortized cost. With effect from July 1, 2001, a gain or
loss on sale of the loan receivables is recognized immediately in
other income. The amount of the gain or loss recognized depends
in part on the previous carrying amount of the receivables
involved in the transfer, allocated between the assets sold and
the retained interests based on their relative fair values at the
date of transfer. To obtain fair values, quoted market prices are
used if available. However, quotes are generally not available for
retained interests and the Bank generally estimates fair value
based on the present value of future expected cash flows estimated
using management’s best estimates of key assumptions – credit
losses, prepayment speeds, forward yield curves, and discount
rates commensurate with the risks involved. Prior to July 1, 2001,
gains arising on loan securitizations were deferred and amortized
to income whereas losses were recognized immediately.
Transactions entered into prior to July 1, 2001 or completed
subsequently pursuant to commitments to sell made prior to
July 1, 2001 have not been restated and deferred gains will be
amortized over the remaining terms of the commitment period.
Subsequent to the securitization, any retained interests that
cannot be contractually settled in such a way that the Bank can
recover substantially all of its recorded investment are adjusted
to fair value. The current fair value of retained interests is deter-
mined using the present value of future expected cash flows as
discussed above.
(j) Acceptances
The potential liability of the Bank under acceptances is reported
as a liability in the consolidated balance sheet. The Bank’s
recourse against the customer in the event of a call on any of
these commitments is reported as an offsetting asset of the
same amount.
(k) Derivative financial instruments
Derivative financial instruments are financial contracts which
derive their value from changes in interest rates, foreign exchange
rates and other financial or commodity indices. Such instruments
include interest rate, foreign exchange, equity, commodity and
credit derivative contracts. These instruments are traded by the
Bank and are also used by the Bank for its own risk management
purposes. To be designated as a non-trading derivative contract
and receive hedge accounting treatment, the contract must
substantially offset the effects of price, interest rate or foreign
exchange rate exposures to the Bank, must be documented at
inception as a non-trading derivative contract, and must have
a high correlation at inception and throughout the contract period
between the derivative contract and the Bank’s exposure. If
these criteria are not met, the contract is designated as a
trading derivative.
Trading derivatives are entered into by the Bank to meet the
needs of its customers and to take trading positions. Derivative
trading portfolios are marked to market with the resulting realized
and unrealized gains or losses recognized immediately in other
income. The market value for over-the-counter trading derivatives
is determined net of valuation adjustments which recognize
the need to cover market, liquidity and credit risks, as well as
the cost of capital and administrative expenses over the life of
each contract.
Non-trading derivatives are entered into by the Bank in
order to meet the Bank’s funding, investing and credit portfolio
management strategies. This is accomplished by modifying one
or more characteristics of the Bank’s risk related to on-balance
sheet financial instruments.