The qualitative component of a credit union's allowance for loan and leases losses (ALLL) is a crucial one. Regardless of the size of a financial institution, a credit union's qualitative factors (Q factors) assessed for their ALLL has been under increased scrutiny by regulators and auditors since the financial crisis six years ago, and that is likely to be the case for the foreseeable future.
With that increased attention in mind, many credit unions find themselves asking what qualitative factors should be used, and how an adjustment to their ALLL calculation should be documented and supported. In fact, many financial institution professionals consider Q factors to be the most challenging piece of their quarterly ALLL. Unlike the historical analysis that is based on hard data, determining Q factors can be a highly subjective exercise. Additionally, there is limited guidance to help institutions determine what, if any, adjustments should be made for their ALLL calculation or what thresholds to use.
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Of the guidance that does exist, the 2006 Interagency Policy Statement is the most frequently referenced. "The nine factors," as they are commonly referred to, are the closest thing to a "safe bet" institutions can get when trying to limit potential regulatory criticism related to Q factor adjustments. Those nine factors look at both internal, institution considerations, as well as external, environmental factors.
This does not mean that credit unions can't go beyond those outlined; additional factors should be used if they more accurately reflect an individual institution's unique risks. The objective is to identify the risk factors that have the potential to influence the collectability of the portfolio.
When adjustments to an institution's ALLL are warranted by Q factors, the presentation of those adjustments to an examiner and/or auditor is critical, and institutions must determine what key drivers will be used to quantify the factors. It is important to demonstrate consistency and transparency, making documentation key. There are two ways that credit union pros can reduce the scrutiny associated with an adjustment:
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Consistent sourcing: Whether you're justifying an adjustment in one of the nine Q factors, or another factor specific and relevant to the institution, it's paramount to ensure your source material is consistent. If during the first quarter of the year, a banker utilized the national unemployment rate from the Federal Reserve Economic Data to assess national economic conditions, then that same source should be used in calculating the adjustment for the third quarter's ALLL as well.
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Qualitative scoring matrix: Use a qualitative scoring matrix – where the factors are outlined and graded using a systematic score – to strengthen the framework around the ALLL calculation and ensure directional consistency. Once adjustments are made, make sure to add relevant comments and cite the data or drivers used to support the adjustments. The comments can be concise, but keep in mind that the goal is to describe the trends observed within the supporting data and thus the reasoning behind the adjustments.
Credit union professionals responsible for the ALLL calculation know that it can be a challenge to serve three masters – those of their key executives and members, auditors and examiners. Ensuring that the subjective material of the Q factors is presented in a clear and consistent way quarter over quarter will serve the important purpose of making the calculation and any adjustments more easily defensible.
The expected and much anticipated transition from the current Incurred Loss Model to the forward-thinking Current Expected Credit Loss model will bring about a lot of change to the ALLL, and qualitative factors are sure to serve a key role. In fact, the role is likely to expand as institutions wrestle with added life of the loan adjustments.
There is no perfect set of Q factors that will fit the needs of every financial institution. For many credit unions, however, selecting a few data sources that can be routinely analyzed and documented for each Q factor will help to simplify the process. Furthermore, added focus on key data drivers along with proper documentation will go a long way to support consistency and transparency in the reserve calculation in your presentations to executives, auditors and examiners.
Aaron Lenhart is a risk management consultant for Sageworks. He can be reached at 919-851-7474 or [email protected].
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