Managing Your Allowance Through the COVID/CECL Crossroads

At the beginning of 2020, because of the COVID-19 pandemic, credit unions, along with the rest of the world, saw threats to safety and soundness. Not only financial safety and soundness but threats to physical safety and soundness. The response at credit unions was multi-faceted. First it was ensuring the physical safety of members and staff. Then it was tending to the financial need of members, which took shape by providing extensions and/or short-term funding to consumers and securing Paycheck Protection Loans for business members. Once the members were served, it became time to consider the impacts to financial statements and loan loss reserves.

In 2020 credit unions began building up their allowance for loan loss reserve by taking additional provision for loan loss expense. As a result, allowance for loan losses at credit unions rose from approximately 0.86% of loans as of Dec. 31, 2019 to approximately 1.11% of loans as of Dec. 31, 2020.

As reserves at credit unions were increasing, delinquency and charge-offs were falling. Charge-off ratios fell from 67 bps to 56 bps and delinquency fell from 68 bps to 59 bps.

It’s been over a year since the economy was shaken by the COVID-19 pandemic. The dust has begun to settle and economies have begun reopening. While some uncertainty remains, it is starting to become more likely that the impacts to credit union losses will be less than expected.

Most financial professionals agree that a conservative allowance in the face of uncertain times is appropriate. However, now credit unions are asking how they should manage their allowance for loan loss reserve in a post-COVID environment. Should they begin reducing their reserves, or should they continue to build reserves in the face of the upcoming Current Expected Credit Loss (CECL) rules? If they choose to begin reducing reserves, is it appropriate to credit provision for loan loss expense, or better to allow loans charged off to erode reserves?

As a CPA and president of 2020 Analytics, which has been working with credit unions for over 10 years, I understand the decision is a complex one. The allowance for loan and lease loss reserve is the most significant estimate on your balance sheet and requires professional judgment.

First, from a technical accounting perspective, credit unions should not consider future CECL implementation in their determination of incurred loss driven reserves. It’s simply not appropriate. From a practical standpoint, credit unions may continue to carry conservative reserves, but these should be supported by reasonable and supportable qualitative adjustments under current Generally Accepted Accounting Principals.

Now is the time for credit unions to assess the state of their allowance.

Because they’re typically based on consistent and objective information, reserves for loans under FAS 5 (homogenous loan pools) are likely appropriate. Additionally, loans individually reserved for under FAS 114 are relatively straight forward, although credit unions should consider the current state of collateral markets in their determination of reserves. If you’re reconsidering the appropriateness of your reserve as we emerge from the pandemic, your qualitative and environmental (Q&E) adjustments are likely the place to start.

Consider the changes in credit and collateral quality of your portfolio, including delinquency. You might also reconsider subjective reserves tied to the pandemic, either arbitrarily or tied to economic indicators like unemployment.

According to the Bureau of Labor Statistics, unemployment rates fell to 5.8% in May of 2021 from a high of 14.8% in April 2020. If you created a qualitative and environmental reserve under the assumption that the 14.8% number would hold long-term, your Q&E reserves likely require adjustments.

The degree in which you’re overstated and the approach you might take in adjusting your reserves require the most professional judgment. I’m hesitant to say that we’re completely out of the woods at this point. Many borrowers who experienced severe financial impact because of the COVID-19 pandemic have continued to receive assistance. Additionally, special credit reporting codes put in place by the Consumer Data Industry Association have insulated borrowers’ credit scores from downward migration because of pandemic driven financial difficulty.

To smooth the income statement impact of a sharp one-time adjustment while maintaining a layer of conservatism in the event we do see delayed impacts from the pandemic, I suggest comparing your current allowance (Point A) to where your allowance might be had we not been hit with this pandemic (Point B). Consider reducing your qualitative reserves from Point A to Point B over some reasonable time period (such as 12 months) if we aren’t hit with any economic surprises over that time period. For some credit unions, this will mean taking a credit to provision for loan loss expense, which would be appropriate if supportable.

Your allowance for loan loss reserve is an estimate. Assuming your loan loss estimates through COVID-19 were reasonable and supportable, to say that your qualitative adjustments were too high in retrospect is not an admission that your historical reserves were inappropriate. However, continuing to maintain those levels of reserves as more positive economic conditions present themselves might be.

Dan Price, CPA, CFA is President of 2020 Analytics, a loan portfolio analytics provider based in Clearwater, Fla.