For many financial institutions across the country, the overall economic conditions during 2019 exhibited the trends associated with a stable and robust lending environment, with low unemployment rates, improving delinquency rates, and a steady, positive outlook in consumer demand. Now, as financial institutions begin wrapping up their financial results for the first quarter of 2020, the vast economic uncertainty created by the world-wide spread of the coronavirus and the inevitable financial hardship it’s imposing on their customers leaves financial institutions in the precarious position of needing to evaluate the adequacy of the allowance for loan losses (ALL) before the impact of COVID-19 has been fully incorporated into traditional economic factors.
For those financial institutions that have not adopted Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2016-13, Measurement of Credit Losses on Financial Instruments, or otherwise referred to as the Current Expected Credit Loss (CECL) methodology, the applicable accounting guidance still remains based on the incurred-loss model components under generally accepted accounting principles (GAAP). One of the underlying practices commonly used in the incurred-loss methodology involves computing historical loss rate percentages for each identified loan pool over a specified time frame and applying qualitative factor adjustments to those historical loss rate percentages to form an estimate of the credit losses inherent in those loan pools collectively evaluated for impairment.
It’s likely within these qualitative factor adjustments, or creation of an unallocated reserve, that financial institutions may want to consider incorporating the current environment into the allowance model. A key point to remember is that any estimates related to the effects of COVID-19 under the incurred-loss model should include amounts that represent probable losses that can be reasonably estimated and supported by evidence as of the evaluation date.
Financial institutions applying the legacy incurred-loss model traditionally incorporate and consider the nine qualitative factors included in the 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses, which involve changes in:
- Lending policies and procedures
- Economic and business conditions
- Nature and volume of the loan portfolio and in terms of loans
- 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
- Existence and effect of any concentrations of credit
- Other external factors, including but not limited to competition and legal or regulatory requirements
Financial institutions’ ability to capture and assess relevant data from both external sources and internal reports on loan customers affected by the COVID-19 pandemic over the next several months will be the key starting point in assembling supporting documentation for substantiating revisions to these qualitative factor components. Begin compiling the data and recognize that many well-publicized articles at this point have mainly hypothesized the negative economic consequences related to COVID-19, but better clarity will evolve as more formal economic data from federal, state and local governments starts to be published.
Incorporating COVID-19 into qualitative factors
Here are some possible strategies that may be beneficial for financial institutions to consider while preparing the qualitative factor components within the allowance for loan losses.
- Subsequent information obtained after quarter-end – Institutions are allowed to use data published after the quarter-end if it provides supportive information that existed as of the quarter-end. For example, the United States Department of Labor recently published the unemployment claims for the last week of March 2020 at 6.8 million in early April, along with the significant increase in the national unemployment rate to 4.4%. This information would be appropriate to consider for current changes in economic and business conditions.
- Nontraditional sources – Qualitative factor analysis normally includes very specific sources of published data and defined information from customary internal loan system reporting. However, with appropriate documentation and justification, it’s acceptable to consider information from other reliable sources. This may allow institutions to incorporate the impact of COVID-19 into their loan portfolios in a more accurate or timely manner.
- No future or lifetime losses – With the economic disruption of COVID-19, there has been a lot of discussion about the lifetime expected losses under the CECL standard. While reasonable forecasts of future economic conditions are prescribed under the CECL standard, it’s important to remember that the legacy incurred-loss model follows the existing guidance in FASB Accounting Standards Codification (ASC) Topic 450, Contingencies. As mentioned previously, ASC 450 limits the recognition of losses to those that have been incurred and are reasonably estimable. Attempting to reserve for future losses or implement lifetime expected-loss reserves without formally adopting CECL should be avoided.
Unallocated reserves within the ALLL
Over the past several years of improving economic trends following the period often referred to as the
“Great Recession, ” external auditors and regulators have been hesitant to accept unallocated reserve balances. Greater emphasis has been placed on institutions incorporating risk uncertainties into the qualitative factor analysis and applying these to the respective loan pools. 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 specifically refers to the appropriateness of an unallocated reserve amount “when it reflects an estimate of probable credit losses, determined in accordance with GAAP, and is properly supported.”
A financial institution that chooses to include an unallocated reserve will need to prepare documentation that clearly demonstrates uncertainty in the collectability of loans within its portfolio and the probability of incurred losses. This documentation should support: a) why the institution believes a loss has been incurred and the loss’s impact on the loan portfolio; b) how the loss is not captured in the systematic methodology used to prepare the ALLL; and c) why the amount of unallocated reserve is appropriate, given the institution’s specific loan composition, identified loan concentrations, and risk profile. The amount of unallocated reserve needed is a judgment made by the institution’s management and requires balancing out the need to recognize a loss in an unprecedented economic situation while adhering to the principles underlying the incurred-loss model that prohibit recognition of future or lifetime losses.
Institutions applying the CECL standard
The underlying concept of the CECL standard is centered on applying the estimation and recognition of future or lifetime credit losses, which include the reasonable and supportable estimations of future economic conditions. Since the CECL standard also maintains the concepts of the qualitative factors applied under the incurred-loss model, many of the considerations discussed earlier are likely to apply to those institutions who have already adopted the CECL standard, even though most CECL models are more precisely calibrated to forecasted economic information without consideration of unparalleled times such as the one being experienced under COVID-19.
Financial institutions applying the CECL concepts will undoubtedly need to carefully determine whether their model inputs have appropriately captured the estimated lifetime loss impact resulting from COVID-19. Given the uncertainty around both the length and severity of the economic fallout from COVID-19, management will need to support its judgment 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 institutions’ model inputs do not fully capture the expected impact of COVID-19.
Wipfli can help
Please contact your Wipfli relationship professional for more information on the COVID-19 impact considerations related to the allowance for loan losses. In these ever-changing and uncertain times brought about by the COVID-19 pandemic, Wipfli is dedicated to closely monitoring the COVID-19 situation as it evolves and is providing insights and informational resources to assist you with the various issues that confront your financial institution.