Due to their subjective nature, the qualitative and environmental factor adjustments often draw more scrutiny and criticism by examiners than any other component of the ALLL calculation. There is little guidance provided by regulatory agencies surrounding the qualitative portion of the ALLL, but it is clearly stated that any adjustments must be clearly documented and directionally consistent.
Guidance does provide nine recommended qualitative factor categories through which financial institutions can account for any disparities between the reserve amount as calculated in the quantitative portion of the calculation and what they believe to be the true amount of expected credit losses within their portfolio (including environmental considerations).
Ways to add objectivity to this portion of the calculation include directional consistency (ensuring that adjustments always follow documented trends), incorporating a qualitative scoring matrix, and backtesting as a method of validating the accuracy of your previous qualitative adjustments.
qualitative scoring matrix
Defending Qualitative Factors
When it comes to defending Q factors, documentation is key. An institution will be well suited to defend their qualitative and environmental risk factors if they are objective, directionally consistent, and properly document their assumptions.
Standard Qualitative Factors
The 2006 Interagency Policy Statement on the ALLL included recommendations for nine qualitative factors. These consist of six internal factors, which focus on changes within the institution (ex. “Quality of the organization’s loan review system”), and three external qualitative factors, which pertain to the outside environment and are independent of the institution’s performance (ex. “International, national regional and local conditions”).
Backtesting Qualitative Factors
Backtesting refers to retroactively validating the accuracy of an institution’s methodology. This consists of pinning the ALLL calculation against actual credit losses to determine the degree of variance. If an institution’s prior backtesting efforts show that their allowance calculation has consistently been accurate with their qualitative adjustments, it can serve in the defensibility of the ALLL and in justifying Q factor adjustments moving forward.
Objectivity in Adjustments
There are various measures institutions can take to add objectivity to the otherwise subjective task of qualitative and environmental risk factors. These consist of incorporating a qualitative scoring matrix into your Q factor analysis, ensuring directional consistency, and sticking to the nine recommended Q factor adjustments, among other things.