We establish an allowance for loan losses that represents our estimate of probable losses in our loan portfolio . The responsibility for determining our allowance for loan losses rests with credit risk management. The components of this allowance are:
Specific Loss Component: Allowances we maintain to cover the default risk of specific exposures.
Inherent Loss Component- Country Risk Allowance: Allowances we maintain to cover credit losses inherent in our pool of cross border loans to borrowers located in certain countries solely as a result of transfer risks.
- Smaller-Balance Standardized Homogeneous Loan Loss Allowance: Allowances we maintain at a portfolio level to cover credit losses inherent in these types of loans.
- Other Inherent Loss Allowance: Allowances we maintain as an estimate of credit losses that we have not otherwise identified.
Specific Loss Component
The specific loss component relates to all loans deemed to be impaired, following an assessment of the counterparty's ability to repay. A loan is considered to be impaired when we determine that it is probable that we will be unable to collect all interest and principal due in accordance with the terms of the loan agreement. We determine the amount, if any, of the specific provision we should make, taking into account the present value of expected future cash flows, the fair value
of the underlying collateral or the market price of the loan.
We regularly re-evaluate all credit exposures that have already been specifically provided for, as well as all credit exposures that appear on our watchlist.
Inherent Loss Component
The inherent loss component relates to all other loans we do not individually provide for, but which we believe to have incurred some inherent loss on a portfolio basis.
Country Risk Allowance. We establish a country risk allowance for loan exposures in countries where we have serious doubts about the ability of our counterparties to comply with the repayment terms due to the economic or political situation prevailing in the respective countries of domicile, that is, for transfer risks. We determine the percentage rates for our country risk allowance on the basis of a comprehensive matrix that encompasses both historical loss experience and market data, such as economic, political and other relevant factors affecting a country's financial condition. In making our decision, we focus primarily on the transfer risk ratings that we assign to a country and the amount and type of collateral.
Smaller-Balance Standardized Homogeneous Loan Loss Allowance. Our smaller-balance standardized homogeneous portfolio includes smaller-balance personal loans, residential and nonresidential mortgage loans, overdrafts and loans to self-employed and small business customers of our private and retail business. These loans are evaluated for inherent loss on a collective basis, based on analyses of historical loss experience from each product type according to criteria such as past due status and collateral recovery values. The resulting allowance encompasses the loss inherent both in current and performing loans, as well as in delinquent and nonperforming loans within the smaller-balance standardized homogeneous loan portfolio.
Other Inherent Loss Allowance. This component of the allowance represents an estimate of our inherent losses resulting from the imprecisions and uncertainties in determining credit losses. This estimate of inherent losses excludes those exposures we have already considered in the specific loss component as described above or considered when establishing our allowance for smaller-balance standardized homogeneous loans. We have historically used a ratio of an entity's historical average losses (net of recoveries) to the historical average of its loan exposures, the result of which we applied to our corresponding period end loan exposures and adjusted the result for relevant environmental factors. As a consequence of our improved risk management processes and capabilities, in 2002 we refined the measure for calculating our other inherent loss allowance. This refinement was made in order to make the provision more sensitive to the prevailing credit environment and less based on historical loss experience. The new measurement incorporates the expected loss results, which we generate as part of our economic capital calculations, outlined above. Therefore, the new measurement considers, among other factors, our internal rating information which results in a better reflection of the current economic situation and consequently provides better guidance for losses inherent in the portfolio that have not yet been individually identified.