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Loan Quality

Bank management can focus on four related key measures to establish a current and prospective view of possible loan loss. These four measures are Non-Performing Assets, Allowance for Loan Loss, Net Charge-Offs, and Loan Loss Provision.

Begin by looking at Non-Performing Assets which are primarily past-due, non-accruing, and foreclosed loans. Such "assets" represent past credit decisions which are now recognized as bad loans. Non-Performing Assets are a drag on current earnings and an indication of what may need to be charged-off in the future.

Next look at the Allowance for Loan Loss which is the bank's reserve for bad debts. It represents prior charges against earnings which can absorb current and future charge-offs. When viewed in comparison to Non-Performing Assets, the adequacy of current reserves can be judged. If the Allowance is below the Non-Performing Assets, additional provision expense may be necessary.

The next measure, Net Charge-Offs, represents loans actually charged-off, net of recoveries. The current amount and trend of charge-offs is an indication of prior credit decisions and managementís balance sheet philosophy. A steady amount of charge-offs at a low level indicates that some bad debts are simply a cost of doing business. Large swings in charge-offs are an indication of surprises and the possibility of less than adequate credit approval procedures.

Finally, Loan Loss Provision is the current loss expense recognized for the lending and credit function. When viewed in comparison with the charge-offs over time, the provision indicates whether the expense provision is required to build reserves for a growing loan portfolio or is required to absorb the bad and charged-off loans in excess of the current reserve position.

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