Qualitative risk factors in the ALLL calculation
The ALLL calculation is certainly a complex process for financial institutions. And perhaps one of the biggest challenges it presents is how to handle qualitative risk adjustments, through which a bank adjusts for environmental and qualitative factors that may impact losses.
These qualitative adjustments for ALLL are a challenge because they are inherently subjective in nature. The 2006 Interagency Policy Statement on the ALLL provides little direction on how these determinations should be made, advising only that “management should consider those current qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the group’s historical loss experience.” It further vaguely explains that these determinations are to be “based on a comprehensive, well-documented and consistently applied analysis of its loan portfolio.”
While the ambiguity on how these qualitative adjustments are to be made provides management teams with tremendous leeway, it also exposes institutions to significant regulatory scrutiny. Here are some recommendations for how management can approach qualitative factors in the ALLL methodology more objectively.
1) Follow Interagency Guidance
2) Create a Standard Process of Review
3) Utilize Current Market Information
4) Provide Directional Consistency
5) Conduct Correlation Analysis
6) Use Back-Testing as a Method of Validation