Fifth Third Bank 2008 Annual Report Download - page 19

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Fifth Third Bancorp 17
CRITICAL ACCOUNTING POLICIES
The Bancorp’s Consolidated Financial Statements are prepared in
accordance with accounting principles generally accepted in the
United States of America. Certain accounting policies require
management to exercise judgment in determining methodologies,
economic assumptions and estimates that may materially affect
the value of the Bancorp’s assets or liabilities and results of
operations and cash flows. The Bancorp has six critical
accounting policies, which include the accounting for allowance
for loan and lease losses, reserve for unfunded commitments,
income taxes, valuation of servicing rights, fair value
measurements and goodwill. No material changes have been
made during the year ended December 31, 2008 to the valuation
techniques or models described below.
Allowance for Loan and Lease Losses
The Bancorp maintains an allowance to absorb probable loan and
lease losses inherent in the portfolio. The allowance is maintained
at a level the Bancorp considers to be adequate and is based on
ongoing quarterly assessments and evaluations of the collectibility
and historical loss experience of loans and leases. Credit losses
are charged and recoveries are credited to the allowance.
Provisions for loan and lease losses are based on the Bancorp’s
review of the historical credit loss experience and such factors
that, in management’s judgment, deserve consideration under
existing economic conditions in estimating probable credit losses.
In determining the appropriate level of the allowance, the
Bancorp estimates losses using a range derived from “base” and
“conservative” estimates. The Bancorp’s strategy for credit risk
management includes a combination of conservative exposure
limits significantly below legal lending limits and conservative
underwriting, documentation and collections standards. The
strategy also emphasizes diversification on a geographic, industry
and customer level, regular credit examinations and quarterly
management reviews of large credit exposures and loans
experiencing deterioration of credit quality.
Larger commercial loans that exhibit probable or observed
credit weakness are subject to individual review. When individual
loans are impaired, allowances are determined based on
management’s estimate of the borrower’s ability to repay the loan
given the availability of collateral and other sources of cash flow,
as well as an evaluation of legal options available to the Bancorp.
The review of individual loans includes those loans that are
impaired as provided in SFAS No. 114, “Accounting by Creditors
for Impairment of a Loan.” Any allowances for impaired loans
are measured based on the present value of expected future cash
flows discounted at the loan’s effective interest rate, the fair value
of the underlying collateral or readily observable secondary market
values. The Bancorp evaluates the collectibility of both principal
and interest when assessing the need for a loss accrual. Historical
loss rates are applied to commercial loans that are not impaired or
are impaired but smaller than an established threshold and thus
not subject to specific allowance allocations. The loss rates are
derived from a migration analysis, which tracks the historical net
charge-off experience sustained on loans according to their
internal risk grade. The risk grading system currently utilized for
allowance analysis purposes encompasses ten categories.
Homogenous loans and leases, such as consumer installment
and residential mortgage loans, are not individually risk graded.
Rather, standard credit scoring systems and delinquency
monitoring are used to assess credit risks. Allowances are
established for each pool of loans based on the expected net
charge-offs. Loss rates are based on the average net charge-off
history by loan category. Historical loss rates for commercial and
consumer loans may be adjusted for significant factors that, in
management’s judgment, are necessary to reflect losses inherent in
the portfolio. Factors that management considers in the analysis
include the effects of the national and local economies; trends in
the nature and volume of delinquencies, charge-offs and
nonaccrual loans; changes in loan mix; credit score migration
comparisons; asset quality trends; risk management and loan
administration; changes in the internal lending policies and credit
standards; collection practices; and examination results from bank
regulatory agencies and the Bancorp’s internal credit examiners.
The Bancorp’s current methodology for determining the
allowance for loan and lease losses is based on historical loss rates,
current credit grades, specific allocation on impaired commercial
credits above specified thresholds and other qualitative
adjustments. Allowances on individual loans and historical loss
rates are reviewed quarterly and adjusted as necessary based on
changing borrower and/or collateral conditions and actual
collection and charge-off experience. An unallocated allowance is
maintained to recognize the imprecision in estimating and
measuring loss when evaluating allowances for individual loans or
pools of loans.
Loans acquired by the Bancorp through a purchase business
combination are evaluated for credit impairment at acquisition.
Reductions to the carrying value of the acquired loans as a result
of credit impairment are recorded as an adjustment to goodwill.
The Bancorp does not carry over the acquired company’s
allowance for loan and lease losses, nor does the Bancorp add to
its existing allowance for the acquired loans as part of purchase
accounting.
The Bancorp’s determination of the allowance for
commercial loans is sensitive to the risk grade it assigns to these
loans. In the event that 10% of commercial loans in each risk
category would experience a downgrade of one risk category, the
allowance for commercial loans increase by approximately $190
million at December 31, 2008. The Bancorp’s determination of
the allowance for residential and retail loans is sensitive to changes
in estimated loss rates. In the event that estimated loss rates
increase by 10%, the allowance for residential and consumer loans
would increase by approximately $100 million at December 31,
2008. As several quantitative and qualitative factors are
considered in determining the allowance for loan and lease losses,
these sensitivity analyses do not necessarily reflect the nature and
extent of future changes in the allowance for loan and lease losses.
They are intended to provide insights into the impact of adverse
changes in risk grades and estimated loss rates and do not imply
any expectation of future deterioration in the risk ratings or loss
rates. Given current processes employed by the Bancorp,
management believes the risk grades and estimated loss rates
currently assigned are appropriate.
The Bancorp’s primary market areas for lending are the
Midwestern and Southeastern regions of the United States. When
evaluating the adequacy of allowances, consideration is given to
these regional geographic concentrations and the closely
associated effect changing economic conditions have on the
Bancorp’s customers.
Reserve for Unfunded Commitments
The reserve for unfunded commitments is maintained at a level
believed by management to be sufficient to absorb estimated
probable losses related to unfunded credit facilities and is included
in other liabilities in the Consolidated Balance Sheets. The
determination of the adequacy of the reserve is based upon an
evaluation of the unfunded credit facilities, including an
assessment of historical commitment utilization experience, credit
risk grading and credit grade migration. Net adjustments to the
reserve for unfunded commitments are included in other
noninterest expense in the Consolidated Statements of Income.