Qualitative adjustments, otherwise known as Q factors, have been steadily increasing in influence on the reserves held for pooled loans since the end of the recession, and their role in estimating the allowance may change yet again under the current expected credit loss model, or CECL.
During a recent webinar on qualitative adjustments and economic forecasting, Sageworks risk management consultant Tim McPeak noted that an increasing reliance on Q factors for the reserve, in addition to changing qualitative models, has caused auditor scrutiny in the past few years. To gauge how important the subjective side of the allowance calculation has become to financial institutions, Sageworks in June 2018 examined aggregate data for its 700+ ALLL customers.
The results showed that in 2011, Q factors made up only 15 percent of reserves for pooled loans. Since the beginning of 2017 and into 2018, Q-factors made up around 71 percent of reserves for pooled loans. This means that for every dollar of a pooled reserve, 71 cents was coming from qualitative adjustments.
McPeak explained that some institutions are moving to a driver or matrix-based approach when applying their Q factors, which is a more systematic and quantitative model than the common practice of simply adding or subtracting basis points to loss rates from trends in internal or external data.
“I think that the reason for this is that there has been continual pressure, typically from the audit side of the world, specifically on Q-factors because they are inherently subjective and that makes them very difficult for auditors to audit effectively,” McPeak said. ”Because it is such a large portion of the reserve, it gets harder and harder for them to justify that and is where a lot of that pressure has been coming from.”
The recent trend of increasing qualitative adjustments is likely due to a low loss, low default environment. Going back to the tail end of the recession, there was a meaningful drop in industry default levels, from a 2.65 percent nonaccrual rate of total loans in 2011 to a 0.864 percent rate in 2017, according to Sageworks Peer Analysis.
However, as McPeak discussed on the webinar, although there has been a downward trend of reserve levels (i.e., the allowance compared to total loans by year has come down from 2011 to 2017), the change is minimal compared to the drop in default levels. It seems that ALLL levels have not decreased as much as would be expected if they reflected the overall improvement in portfolio quality, which could be due to the reliance of institutions on qualitative adjustments.
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Changes to expect with qualitative adjustments under CECL
McPeak said during the webinar that even if auditors and regulators would generally like to see less reliance on Q factors, they are not going away under CECL. The standard states: “Because historical experience may not fully reflect an entity’s expectations about the future, management should adjust historical loss information, as necessary, to reflect current conditions and reasonable and supportable forecasts nor already reflected in the historical loss information.” The “current conditions” emphasized in the standard represents qualitative factors, which are adjustments that are not reflected in an institution’s historical loss, McPeak said.
Although the standard refers to qualitative adjustments and reasonable and supportable together, McPeak predicted that these are likely to be separately documented processes as opposed to a combined one moving forward.
“The reason I say that is I think it will be really important to delineate between current conditions — the things I have evidence for today — as opposed to explicitly forward-looking aspects. One of the concerns from an auditor and examiner standpoint is going to be around double-counting to make sure that institutions are not double counting adjustments, which will inflate reserve levels,” he said.
Not only won’t Q factors disappear under CECL, but McPeak said it’s also unclear whether institutions will even reduce reliance on Q factors to maintain appropriate reserve levels under CECL. Although that may be the most positive case for those involved in the ALLL calculation process for preventing auditor and examiner scrutiny, it might not be a reality due to such a large reliance on them. The move from an annual to lifetime loss requirements should increase the quantitative side of the ALLL, however, it is unlikely that the documentation of more loss will make up for how frequently Q factors are being used, according to McPeak.
In a poll during the webinar, 27 percent of the 225 representatives from banks and credit unions said that it’s unclear how much they will rely on Q factors under CECL relative to current practices. A similar percentage of bankers said they expect little to no changes in their use of Q factors under CECL.
“I am a little surprised that there were not more responses in the ‘it is not clear yet’ category,” McPeak said. “I think that there is a desire to be less reliant on them under CECL. As institutions start working on their transition structures and move toward parallel calculations, we can get a better idea of whether or not this will be the case.” To receive more information about CECL Q factors and economic forecasting, access the on-demand webinar, “Subjective CECL: Qualitative Adjustments and Forecasts Under the CECL Model.”
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Webinar: Subjective CECL: Qualitative Adjustments and Forecasts Under the CECL Model