Huntington National Bank 2004 Annual Report Download - page 53

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MANAGEMENT’S DISCUSSION AND ANALYSIS HUNTINGTON BANCSHARES INCORPORATED
Allowances for Credit Losses
(This section should be read in conjunction with Significant Factors 1, 4 and 8.)
The Company maintains two reserves, both of which are available 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 allowances for credit losses (ACL). The Credit Administration group is responsible for developing the
methodology and determining the adequacy of the ALLL and AULC.
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, while reductions reflect charge-offs, recoveries, or the sale of loans.
P
ROCESS TO
D
ETERMINE THE
A
DEQUACY OF THE
ALLL
Management has an established process to determine the adequacy of the ALLL 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 three components: the transaction reserve, specific reserve, and the economic reserve.
Transaction Reserve
The transaction reserve component represents an estimate of loss based on characteristics of each commercial and consumer loan
or lease in the portfolio. Each loan and lease is assigned a probability-of-default and a loss-in-event-of-default factor that are
used to calculate the transaction reserve.
For middle market commercial and industrial, middle market commercial real estate, and small business loans, the calculation
involves the use of a standardized loan grading system that 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 the
Company’s 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 component 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.
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.
Specific Reserve
The specific reserve component is associated only with the middle market commercial and industrial, middle market commercial
real estate, and small business segments and is the result of credit-by-credit reserve decisions for individual loans when it is
determined that the calculated transaction reserve component is insufficient to cover the estimated losses. Individual non-
performing and substandard loans over $250,000 are analyzed for impairment and possible assignment of a specific reserve. The
impairment tests are done in accordance with applicable accounting standards and regulations.
Economic Reserve
Changes in the economic environment are a significant judgmental factor management considers in determining the appropriate
level of the ACL. The economic reserve incorporates Management’s determination of the impact of risks associated with the
general economic environment on the portfolio. 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 ALLL calculation, Management developed a revised methodology for
calculating the economic reserve portion of the ALLL for implementation in 2004. The revised methodology is specifically tied to
economic indices that have a high correlation to the Company’s 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 portfolio performance
changes over time. Management has the capability to judgmentally adjust the calculated economic reserve amount by a
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