Getting the most out of Q Factors
Supporting ALLL environmental factors presents a challenge for all financial institutions. Yes, the 2012 Interagency Guidance on ALLL highlights nine specific factors banks should consider, but there is little instruction on how those factors should or could be substantiated.
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”).
Reporting: Benefit Beyond Compliance
Above and beyond regulatory expectations for disclosure reporting, Rhoda Lauver of Jonestown Bank and Trust Company in Lebanon, Pennsylvania, believes that reporting on ALLL results should be pervasive throughout many areas of the bank.
Justification of Qualitative and Environmental (Q/E) Considerations
As required by regulatory and accounting guidelines, historical loss experience is the starting point for estimating future loss expectations. In a stable environment without significant changes in process, personnel, or portfolio concentration, historical experience offers a reasonable approximation of expected future losses. However, a constantly changing environment requires management to assess how changes may affect future losses.
Institutions should begin to gather the necessary documentation, both internal and external, before commencement of the ALLL calculation. Many sources of information, such as appraisal values or cash flow schedules, may require updating prior to the time of the calculation. As such, institutions should be mindful of documentation requirements as they begin to plan for their ALLL calculation.
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.