A qualitative scorecard for the allowance provides a framework that enables the financial institution’s management team to determine reasonable and supportable Q factor adjustments to the quantitative baseline estimate. The scorecard is a reliable and consistent mechanism that can be backtested against subsequent performance, too.
Here’s how scorecard development works:
- Review the quantitative model(s)/methodology that will be used to calculate the baseline loss estimate.
- Identify quantitative metrics that assist in framing various risk scenarios, from minor to major.
- Leverage peer analysis against historical loss experience to determine a high- and low-mark estimation framework.
- Identify appropriate scorecard frameworks to specific circumstances and institution preferences.
- Create a qualitative scorecard for each allowance pool based on the broadly or uniquely identified selections (or a combination of both).
Currently, many institutions use the same Q factor for the entire portfolio, but under CECL, qualitative adjustments may differ on a pool-by-pool basis. “Depending on the nature of the asset, not all of the factors may be relevant and other factors also may be relevant and should be considered,” according to a 2019 Frequently Asked Questions (FAQs) on CECL by regulators.
A qualitative adjustment scorecard can simplify the quarterly process of developing and documenting Q factors, especially if the scorecard can be interconnected with the financial institution’s CECL model.
“To assess a Q factor, you have to know what’s in the quantitative model and the limitations of it,” said Moore. “A qualitative scorecard, therefore, should ensure that the qualitative aspects are not ignorant of the quantitative aspects. They should ‘talk’ to each other.”
This is also an advantage of the scorecard when it comes to financial reporting from period to period. As credit losses associated with Q factors are recognized and the quantitative portion of the allowance is updated, the concomitant qualitative factor adjustments drop off the scorecard.
Q factors aren’t going away under CECL. And while it’s impossible to provide a blanket assessment of how every institution’s Q factor adjustments will compare to those under the incurred-loss method, it’s a certainty that auditors and regulators will be focused on understanding the reasoning behind adjustments, as well as how the adjustments were determined. Using a qualitative scorecard can make this process easier and more consistent for financial institutions.