9 Standard Qualitative Factors for the ALLL
The 2006 Interagency Policy Statement on the ALLL provides limited direction for financial institutions on the management of qualitative and environmental adjustments. The primary source of guidance comes in the form of nine “universal” qualitative adjustment categories financial institutions can use in their analysis.
These nine factors consist of:
- Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses.
- Changes in international, national, regional, and local economic and business conditions and developments that affect the collectibility of the portfolio, including the condition of various market segments.
- Changes in the nature and volume of the portfolio and in the terms of loans.
- Changes in the experience, ability, and depth of lending management and other relevant staff.
- Changes in the volume and severity of past-due loans, the volume of non-accrual loans, and the volume and severity of adversely classified or graded loans.
- Changes in the quality of the institution’s loan review system.
- Changes in the value of underlying collateral for collateral-dependent loans.
- The existence and effect of any concentrations of credit, and changes in the level of such concentrations.
- The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the institution’s existing portfolio.
Overcoming Q-Factor Challenges
Qualitative factors and environmental factors, also known as q-factors, are used to reflect risk in the portfolio not captured by historical loss data. Q-factors are the primary lever for banks to alter their ALLL assumptions beyond the quantitative portion, and they 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. Because of their subjective nature, q-factors can draw scrutiny from auditors and regulators. To justify q-factors, financial institutions should use the recommended factors, a qualitative scoring matrix, management committees, and statistical analysis. Other ways to overcome q-factor challenges include:
- Quantitating q-factors
- On a basic level: Identifying big-picture drivers and ensuring directional consistency
- On an advanced level: Using multivariable regression against charge-offs/NPLs to identify drivers
- Applying internal controls and processes that improve consistency in documentation and defense
- Setting appropriate ranges of adjustments