The ALLL today – Qualitative factor challenges
With the recent release of the Financial Accounting Standards Board’s (FASB) guidance on the CECL model, banking professionals and consultants have been theorizing about the impact the standard will have on current bank processes. While it is important for these banking professionals to be prepared, consultants are stressing the importance of tackling today’s allowance challenges too.
Qualitative or environmental factors, also known as Q-factors, are the primary lever for banks to alter their ALLL assumptions beyond the quantitative portion. Q-factors allow for adjustments to the historical-loss experience to reflect losses embedded in the portfolio that have not been captured in charge-offs and recoveries.
The challenges associated with Q-factors adjustments are not new, but reliance on Q-factors has increased scrutiny from auditors and regulators. Banks can limit these external pressures by improving their Q-factor analyses in several ways outlined below.
“Q-factor adjustments and support justification are current challenges bankers face and several they will continue to face as they transition of an expected loss model. To better justify Q-factors banks should use the recommended factors, a qualitative scoring matrix, management committees or surveys, and statistical analysis,” said Sageworks Executive Risk Management Consultant, Tim McPeak.
Q-Factor Challenges:
- Making qualitative factors more quantitative for auditors and regulators
- Identifying underlying drivers for risk factors
- Justifying & documenting adjustment scales and ranges
- Application only relevant for current period and not forward looking
Q-Factor Solutions:
- Quantitating Q-factors – Basic: Identify big-picture drivers and ensure directional consistency Advanced: Multivariable regression against charge-offs/NPLs to identify drivers
- Apply internal controls and processes that improve consistent documentation and defense
- More quantitative model also risk losing flexibility
- Setting appropriate ranges of adjustments is critical
In the end, this is still management’s responsibility to adjust reserve levels
