Documentation of Qualitative
Factors for the ALLL
Dorsey Baskin, Partner
Grant Thornton LLP
September 2015
Meet our specialist
Dorsey Baskin
Managing Partner of Assurance Service Development
T 214.561.2328
E [email protected]
Dorsey, a national office partner located in Dallas, Texas, joined Grant Thornton in 2002 after 25 years with Arthur Andersen.
He is currently Grant Thornton LLP’s Managing Partner for Innovative Services Development wherein he is responsible for
identification, development and orchestration of new services, such as, for example, with respect to new Allowance for Loan
and Lease Losses standards. In addition to this role, Dorsey continues to serve clients through technical consultations and
continues to support the firm’s outreach to the academic community. He is involved on a national basis with financial
services-related technical matters, especially with respect to loan and ALLL accounting, and in this role he is directly
accessible to engagement teams and clients.
While at Andersen he spent 10 years in Washington, D.C. as the National Technical Director for Depository Institutions, which
included acting as the firm’s liaison with the bank and thrift regulatory agencies, particularly their accounting policy and
examinations staffs. Dorsey has served on several AICPA committees and task forces, including as Chairman of the AICPA
Thrift Committee and member of the combined Bank and Savings Institutions Committee. He was a member of task forces
related to FDICIA Implementation, Trade Date versus Settlement Date, Accounting for ADC Loans, Other Than Temporary
Impairment, and SAB 99 (Materiality). He was chairman of the task force that produced SOP 03-3, Accounting for Certain
Loans or Debt Securities Acquired in a Transfer (now ASC 310-30).
Dorsey has authored many papers and articles on bank accounting related matters and has been a frequent speaker at
AICPA, regulatory and other conferences. The series of whitepapers he co-authored for Grant Thornton on various aspects
of the ALLL estimation process are widely used and respected in the banking industry and by regulators.
2
PURPOSE
Documentation of Qualitative Factors for the ALLL
Objectives and Agenda:
• Articulate the conceptual underpinnings of the
adjustment factors used to estimate the ALLL
• Identify relevant guidance regarding documenting
the ALLL
• Describe how to practically combine theory and
guidance
3
PART 1
Documentation of Qualitative Factors for the ALLL
Theory of the ALLL
4
PART 1
Documentation of Qualitative Factors for the ALLL
Theory: the incurred loss model
• Measurement Objective of the
ALLL:
o
Losses incurred as-of
measurement date but not yet
charged-off
• Components of Typical ALLL
Methodology:
o "FAS 114" Impaired Loans
o "FAS 5" Non-Impaired Loans
o Other ("PCI" Loans)
5
THEORY
PART 1
Documentation of Qualitative Factors for the ALLL
Theory: the incurred loss model
6
THEORY
PART 1
Documentation of Qualitative Factors for the ALLL
Theory: the incurred loss model
Measuring incurred losses – the general (FAS 5)
component:
Historical
charge off
experience
•
Adjustments
Loss
discovery
period
Loan
category
balance
FAS 5
(ASC 450)
ALLL
Key factors:
o Historical Charge-Off Rate
o Adjusted by Qualitative Factors
o Adjusted by the Loss Discovery Period
7
PART 1
Documentation of Qualitative Factors for the ALLL
Theory: need for adjustment factors
Adjustment factors are needed to adjust the average charge-off rates
calculated over a historical charge off accumulation period for the
difference between
a) the conditions that existed when the loss-causing events were occurring
that resulted in the charge offs captured in the accumulation period and
b) the conditions that existed during the incurred loss measurement period
leading up to the date of the financial statements.
Adjustment factors are a consequence of:
1) the need to compute historical charge off rates using average
charge off experience that lags current conditions and
2) the loss discovery period that causes charge offs to lag loss
events
8
PART 1
Documentation of Qualitative Factors for the ALLL
Theory: loss discovery period
Loss events
culminate in the
borrower's inability
to repay the loan
The borrower begins to
miss payments, and
problems become
evident to the lender
The lender has sufficient
information to confirm
the loss and takes the
charge-off.
Loss Discovery Period
Performance
continues so that
the loss is not
visible.
Performance deteriorates
so that the loss becomes
visible to the lender.
9
PART 1
Documentation of Qualitative Factors for the ALLL
Theory: adjustment factors
Our observations:
no. 1: The adjustment factors needed in the ALLL methodology depend
on and are explicitly linked to the historical charge off (default)
measurement approach.
no. 2: The length of the historical charge off accumulation period used
to compute the average charge-off rate should be appropriate for the
loan type and support the discovery, measurement and application of
adjustment factors.
no. 3: Development over time of quantified correlations between
economic and other conditions and the resulting historical charge off (or
default) experience is the best empirical, objective, and documentable
means available to compute a reasonable estimate of the ALLL (under
both the incurred loss and CECL models).
10
PART 1
Documentation of Qualitative Factors for the ALLL
Theory: adjustment factors
11
It is advantageous to compute and accumulate correlations over time under different conditions –
assess and document how changes in factors appear to affect subsequent charge off rates
2.0
charge off rate
0.8 1.2 1.6%
unemployment rate
2
5
8%
subsequent charge offs
correlations
Unemployment rate
subsequent
losses
11
PART 1
Documentation of Qualitative Factors for the ALLL
Theory: adjustment factors
12
PART 2
Documentation of Qualitative Factors for the ALLL
Key Guidance
13
PART 2
Documenting the ALLL
Key Guidance
Reference
• SEC Staff Accounting Bulletin: No. 102 – Selected Loan
Loss Allowance Methodology and Documentation Issues
• 1999 Joint Interagency Letter (incl. SEC)
o Agreed on key aspects of the ALLL
• 2001 Interagency Policy Statement / SAB 102
o Focused on what documentation is required to
support the estimate of the ALLL
• 2006 Interagency Policy Statement and Q&A
o Outlines bank management/board obligations
with regard to the ALLL
Future guidance for CECL
Basel Committee of Banking Supervision –
Guidance on accounting for expected credit losses
14
Documentation issues raised in key guidance
• GAO:
October 1994 Report to Congressional Committees, Depository
Institutions: Divergent Loan Loss Methods Undermine Usefulness of
Financial Reports. One of the GAO's principal findings was that most
of the reviewed institutions' loan loss allowances included large
supplemental reserves that generally were not linked to an analysis
of loss exposure or supported by evidence.
15
Documentation issues raised in key guidance
• SAB no. 102:
"In the ordinary course of its reviews of filings, the staff asked a
number of registrants why significant favorable or unfavorable trends
in the quality of the loan portfolio, as evidenced by statistical data
presented in Management's Discussion and Analysis and/or in the
notes to the financial statements, did not correspond with decreases
or increases in the allowance for loan losses reported in the financial
statements. Explanations offered by some registrants have indicated
a lack of reasoned analysis or discipline in the establishment of the
loss allowance. "
"The auditor must obtain sufficient competent evidential matter
supporting the financial statements, and must give adequate attention
to the propriety and accuracy of the data underlying material
assumptions and estimates."
16
Documentation issues raised in key guidance
• 2006 Interagency Policy Statement:
"In carrying out its responsibility for maintaining an appropriate ALLL,
management is expected to adopt and adhere to written policies and
procedures that are appropriate to the size of the institution and the
nature, scope, and risk of its lending activities. At a minimum, these
policies and procedures should ensure that:
• The institution’s process for determining an appropriate level for the
ALLL is based on a comprehensive, well-documented, and
consistently applied analysis of its loan portfolio. The analysis should
consider all significant factors that affect the collectibility of the
portfolio and should support the credit losses estimated by this
process."
17
Summary of guidance
• Every dollar of the allowance must be
supported
• The methodology must comply with
GAAP
• The methodology must be completely
documented
18
PART 3
Documentation of Qualitative Factors for the ALLL
Practice Issues
19
PART 3
Documentation of Qualitative Factors for the ALLL
Practice issues: Q factors
Common issues
• Rote discussion of every one of the "Example Factors"
o not identifying factors driving credit losses
• No tracking of factors during loss accumulation periods
o results in lack of documentation needed for use of factors
• No documented analysis in support of any of applied Q-Factor adjustments
o reliance upon general discussions, all subjective
o easy to support direction of adjustment but then very hard to support amount
20
PART 3
Documentation of Qualitative Factors for the ALLL
Practice issues: Q factors
Rote discussion of "Example Factors"
• 2006 IPS contains a list of possible environmental factors
o Examples, neither all-inclusive or mandatory
What right looks like
• Identify the relevant and primary factors affecting credit performance
o Evaluate other ancillary factors on the margins, if at all
o Use loan categories to track historical charge off experience considering relevant factors
21
PART 3
Documentation of Qualitative Factors for the ALLL
Practice issues: Q factors
Example: SFR 1-4, Senior, Prime
• Main Driver of Credit Loss
– Unemployment
• Secondary Considerations
– Housing Price Index
• Also considered, but little expected impact
– Internal bank changes
– Legal, regulatory changes
22
PART 1
Documentation of Qualitative Factors for the ALLL
Identify and measure correlations
11
It is advantageous to compute and accumulate correlations over time between adjustment factors
and subsequent charge offs under different conditions
2.0
charge off rate
0.8 1.2 1.6%
unemployment rate
2
5
8%
subsequent charge offs
correlations
Unemployment rate
subsequent
losses
23
PART 3
Documentation of Qualitative Factors for the ALLL
Practice issues: Q factors
The computed relationships can be expressed in a table and updated
over time as more experience is gathered.
Unemployment rate
4.5
5
5.5
6
6.5
7
7.5
8
8.5
Related charge-off experience
n/a
0.95
1.05
1.35
1.65
1.80
1.9
2.15
2.5
Using basic historical data, we can develop and document an expectation of the impact of
changes in Unemployment on Historical Losses
24
PART 3
Documentation of Qualitative Factors for the ALLL
Practice issues: Using adjustment factor
Then, using the adjustment factor correlation information,
suggested adjustments to the most recent average charge off rate
can be estimated:
Unemployment rate during loss
discover period (LDP) leading up to the
balance sheet date
7.0%
Based on past history, suggested
annual rate of loss during the LDP
(from table)
1.80 %
Historical average annual charge-rate
during most recent accumulation
period
1.23%
Suggested adjustment factor for
unemployment rate
+0.57%
25
PART 3
Documentation of Qualitative Factors for the ALLL
Practice issues: Using adjustment factor
Need to understand relationships of adjustment factors to losses over
range of conditions
To be useful and appropriate it should be shown and documented that any correlations
between historical experience and adjustment factors are a) significant correlations as
determined mathematically and b) reflect reasonable causation.
26
PART 3
Documentation of Qualitative Factors for the ALLL
Practice issues: Loss Discovery Periods
The length of the LDP can have a material impact
• LDP's have a multiplying effect on adjusted FAS 5 loss rates
• Simply assuming an LDP of 1 year may not be supportable
27
Documentation of Qualitative Factors for the ALLL
Q&A
28