5 Recommendations for determining appropriate qualitative adjustments
While the calculation of the historical loss experience offers a reasonable starting point in determining an appropriate loss rate to be applied against loan pool balances in determining appropriate FAS 5 (ASC 450-20) general reserve levels, “…historical losses, or even recent trends in losses, do not by themselves form a sufficient basis to determine the appropriate level for the ALLL,” according to the 2006 Interagency Policy on the ALLL. The policy also notes that management should consider qualitative and environmental factors.
These qualitative or environmental adjustments to the ALLL are a challenge, because they are inherently subjective in nature. This acknowledged subjectivity offers tremendous leeway in manipulating reserve levels through these adjustments; however, this same leeway also exposes you to significant regulatory scrutiny, proving to be a double-edged sword. Therefore, it is recommended that these determinations be based upon a comprehensive, well-documented and consistently applied analysis of your loan portfolio. The following recommendations are offered to assist you in adding objectivity to this otherwise subjective task and in appropriately and consistently applying these adjustments:
1. Consider regulatory guidance in selecting those qualitative factors that may be appropriate to evaluate in your adjustments. The 2006 Interagency Policy Statement on the ALLL, for example, suggests evaluating nine qualitative factors when estimating potential credit losses.
2. Identify key metrics or drivers behind each of your selected risk factors. Once these drivers are identified, applicable and quantifiable market data is used and documented to determine the appropriate adjustments to the corresponding risk factor. Internal management reports can also be developed to track and support those drivers that may not have quantifiable, external data readily available.
3. Establish a default adjustment matrix supported by previous loss experience. Defining default rate adjustments within an established matrix promotes consistency in your adjustments from one period to the next.
4. Ensure that all adjustments are always directionally consistent with the underlying economic data or the quantifiable evidence utilized to support the qualitative adjustments. Simply put, directional consistency validates that as drivers and factors change direction, an institution’s qualitative rates change direction as well and in accordance with the proper correlation to the driver and factor. Documentation of sequential changes to factor rates, supported with driver graphs and/or measurements, ensures directional consistency has been maintained.
5. Back-test as a method of validation. The utilization of back-testing allows management to test current assumptions or adjustments against actual historical experience, in an effort to utilize the results to add credibility when making those same assumptions or adjustments today. After all, as renowned NYSE trader William Gann taught, “The future is but a repetition of the past.”
For more suggestions and examples on qualitative factors, as well as other portions of the FAS 5 reserve, download the whitepaper: How to Calculate Your FAS 5 Reserves.