One of the most common question we get asked is, “Do Q&E factors apply in CECL?”
The short answer is ‘yes,’ but let’s go into more detail by looking at the purpose of Q&E Adjustments in the first place. If there is reason to believe that a particular pool of loans may experience expected losses that would differ from actual historical losses, Q&E factors can be used to adjust the base loss rate of the given loan pool.
The Interagency Policy Statement on the Allowance for Loan and Lease Losses states the following:
While historical loss experience provides a reasonable starting point for the institution’s analysis, historical losses, or even recent trends in losses, [they] do not by themselves form a sufficient basis to determine the appropriate level for the ALLL. Management should also consider those qualitative or environmental factors that are likely to cause estimated credit losses associated with the institution’s existing portfolio to differ from historical loss experience, including but not limited to:
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 collectability 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 nonaccrual 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.
The CECL accounting standards update has the following similar language.
Because historical experience may not fully reflect an entity’s expectations about the future, management should adjust historical loss information, as necessary, to reflect the current conditions and reasonable and supportable forecasts not already reflected in the historical loss information. In making this determination, management should consider characteristics of the financial assets that are relevant in the circumstances. To adjust historical credit loss information for current conditions and reasonable and supportable forecasts, an entity should consider significant factors that are relevant to determining the expected collectability.
Examples of factors an entity may consider include any of the following, depending on the nature of the asset (not all of these may be relevant to every situation, and other factors not on the list may be relevant):
- The borrower’s financial condition, credit rating, credit score, asset quality, or business prospects.
- The borrower’s ability to make scheduled interest or principal payments.
- The remaining payment terms of the financial asset(s).
- The remaining time to maturity and the timing and extent of prepayments on the financial asset(s).
- The nature and volume of the entity’s financial asset(s).
- The volume and severity of past due financial asset(s) and the volume and severity of adversely classified or rated financial asset(s).
- The value of underlying collateral on financial assets in which the collateral-dependent practical expedient has not been utilized.
- The entity’s lending policies and procedures, including changes in lending strategies, underwriting standards, collection, [write-off], and recovery practices, as well as knowledge of the borrower’s operations or the borrower’s standing in the community.
- The quality of the entity’s credit review system.
- The experience, ability, and depth of the entity’s management, lending staff, and other relevant staff.
- The environmental factors of a borrower and the areas in which the entity’s credit is concentrated, such as:
- Regulatory, legal, or technological environment to which the entity has exposure.
- Changes and expected changes in the general market condition of either the geographical area or the industry to which the entity has exposure.
- Changes and expected changes in international, national, regional, and local economic and business conditions and developments in which the entity operates, including the condition and expected condition of various market segments.
With this information as a backdrop, let’s discuss how Q&E adjustments will change with the adoption of CECL.
One of the biggest changes CECL will bring is the need to consider the “life of loan” timeframe when estimating an expected loss. Another big change CECL brings is expanding the information that should be considered to include “reasonable and supportable” forecasts, which is technically prohibited prior to CECL adoption. So not only are we possibly required to look back further, we are required to look forward a reasonable timeframe. How these two big changes will impact Q&E depends on the loss method applied.
For loss rate type methods that rely on historical losses, such as static pool (cohort), vintage, and loss migration, this concept will extend the typical 12-month lookback period to one which considers lifetime losses—which is typically several years for most loan types. This increase in the lookback period will inherently make it less likely that management will need to adjust base loss rates for factors that are “likely to cause estimated credit losses associated with the institution’s existing portfolio to differ from historical loss experience,” but this highly depends on conditions over the lookback period. With these methods an overt adjustment for forecasts will also need to be made if appropriate.
For loan-level methods, such as probability of default and Visible Equity’s version of discounted cash flow, one must be careful to understand which variables, if any, and timeframes are considered in the model itself. We have found a wide discrepancy in what practitioners refer to as a “probability of default.” Some models really are loss rate based and therefore would fit better in the loss rate type models discussed above. Visible Equity’s model is a true survival-based probability model that incorporates characteristics of the loan, borrower, collateral, payment performance, and economic conditions, including forecasts. With this comprehensive model many of the Q&E factors listed above can be checked off the list.
So yes, qualitative and environmental factors still apply in a CECL world, but they may play a less important role depending on the method deployed.