The end of the first quarter of 2020 leaves financial institutions in the precarious position of needing to recognize an appropriate allowance for loan losses before the impact of COVID-19 has been fully incorporated into traditional economic factors.
Financial institutions may want to consider incorporating the current environment into the allowance model through qualitative factors or an unallocated reserve.
Qualitative Factors
Financial institutions applying the legacy incurred-loss model traditionally consider the nine qualitative factors included in the 2006 interagency guidance:
- Lending policies and procedures
- Economic and business conditions
- Nature and volume of the loan portfolio
- Lending management ability and experience
- Volume and severity of past due, nonaccrual, and adversely classified loans
- Quality of the loan-review system
- Value of underlying collateral for collateral-dependent loans
- Concentrations of credit
- Other external factors, including—but not limited to—competition and legal or regulatory requirements
It’s important to recognize that many well-publicized articles have hypothesized the negative economic consequences related to COVID-19—even if formal economic data from federal, state, and local governments is just starting to be published.
How to Incorporate COVID-19 into Qualitative Factors
The following strategies may be beneficial for financial institutions to consider while preparing the allowance.
Subsequent Information
Institutions are allowed to use data published after quarter-end if it provides information that existed as of quarter-end. If a jurisdiction publishes quarter-end unemployment statistics 10 days later, for example, that information is appropriate to consider.
Nontraditional Sources
Qualitative-factor analysis normally includes very specific sources and defined information. However, with appropriate documentation and justification, it’s acceptable to consider information from other sources. This may allow institutions to incorporate the impact of COVID-19 in a more accurate or timely manner.
No Future or Lifetime Losses
With the economic disruption of COVID-19, there’s been a lot of discussion about lifetime expected losses under the current expected credit loss (CECL) standard. As such, it’s important to remember that the legacy incurred-loss model follows the existing guidance in Financial Accounting Standards Board Accounting Standards Codification (ASC) Topic 450, Contingencies, formerly known as FAS 5.
ASC 450 limits the recognition of losses to those that have been incurred and are reasonably estimable. While institutions may be granted the benefit of the doubt given the extraordinary circumstances surrounding COVID-19, it would be ill-advised to attempt to accrue for future losses or implement lifetime expected-loss reserves without formally adopting CECL.
Unallocated Reserves
Auditors and regulators have been hesitant to accept unallocated reserves in recent years—with an emphasis on institutions incorporating risk uncertainties within the qualitative factor analysis. However, the present situation may be tailor-made for considering an unallocated reserve.
The 2006 interagency policy statement on the Allowance for Loan and Lease Losses (ALLL) specifically refers to the appropriateness of an unallocated amount “when it reflects estimated credit losses determined in accordance with generally accepted accounting principles (GAAP) and is properly supported and documented.”
Proper Documentation
A financial institution that chooses to include an unallocated reserve will need to prepare documentation that clearly demonstrates the following:
- Why the institution believes a loss has been incurred and the loss’s impact on the loan portfolio.
- How the loss isn’t captured in the systematic methodology used to prepare the ALLL.
- Why the amount of reserve is appropriate, given the institution’s specific situation and fact pattern.
The amount of reserve needed is a judgment made by the institution’s management. It has to balance the need to recognize a loss in an unprecedented economic situation while adhering to the incurred loss recognition and measurement principle that prohibits recognition of future or lifetime losses.
Current Expected Credit Loss
Many of these considerations may apply to institutions that have already adopted the CECL standard—even though most CECL models are more precisely calibrated to forecasted and other economic information.
Institutions will need to carefully determine whether the model inputs have appropriately captured the lifetime-loss impact resulting from COVID-19. Given the uncertainty around both the length and severity of the economic-related fallout of COVID-19, management will need to support their judgement about both of these inputs as well as the reasonable and supportable forecast period.
Qualitative considerations similar to those outlined above may also be appropriate if an institution’s model inputs don’t fully capture the expected impact of COVID-19.
We’re Here to Help
For more information about how to recognize the appropriate allowance for loan losses in the midst of the COVID-19 economic disruption, contact your Moss Adams professional.