Many banks have run their CECL and ALLL models in parallel to observe variance trends in the calculated portions (historical loss rates, remaining lives, forward-looking adjustments). While there are many assumptions associated with these calculations, which will be addressed in future articles, one of the biggest tools a bank has at its disposal for shaping its CECL reserve is its custom qualitative factors.
While the other assumptions are directly tied to objective data that is collected by the model, the custom qualitative factors offer bankers a place to adjust based on their own insights, intuition, and local market knowledge. These insights can, of course, be based on objective data of the banks choosing, but it will be entirely independent of any data collected and interpreted by the model itself.
Most banks are using the same general categories that they use for their ALLL models, but not necessarily the same percentage adjustments. Since CECL is a new methodology, it is appropriate to reevaluate the weighting system for the custom factors. There is no objective reason, for example, that the experience of a bank’s lending staff needs to be a 10-basis point adjustment just because that was used in the past. Precedence will be important, though, once the CECL custom factors have been established. If a bank increases its custom factor adjustment for experience of lenders, they should probably have lost an experienced lender.
There are no hard and fast rules about what factors can / should be used, but the most common we have seen in the hundreds of bank we work with are the nine that were suggested by the regulators in 2006 (see pages 8-9 on this link). These leave room for subjectivity, and by having so many factors a bank can make relatively small adjustment to a number of different factors that will make a relatively large impact on the final figures.
Banks are by no means limited to these factors, and there are many environmental factors that could be considered as well (rising interest rates, inflation, supply chain issues, worker shortages, wars, etc.) While the objective forward-looking adjustment certainly takes some of these environmental factors into account, banks can still adjust using their own human judgement based on these factors.
Since losses have been so low in recent years, most banks can come up with a CECL reserve calculation very close to their existing levels, even with the new CECL lifetime multipliers. Those banks that want to keep their existing reserve levels would take smaller custom factors (a general rule-of-thumb would be 20% of their ALLL factors).
However, it may be worth considering whether to use larger factors to take advantage of the one-time opportunity provided by the regulators as an accommodation to banks. In the quarter they go live, banks can take the difference in the reserve from their CECL calculations and their ALLL calculations straight out of capital without having to take a loan loss provision.
CECL will cause bank reserves to be more sensitive to changing market conditions. A small change in historical loss rates will result in a much larger change in lifetime loss rates. If a bank has not already built a strong loan loss reserve cushion, this one-time opportunity might be the perfect time to do so to mitigate large increases in future reserve calculations.
We have seen substantial variations in the size of custom factors for our clients. There is no shortage of reasons to add to custom factors these days. It really comes down to justifying the factors as reasonable and supportable to the regulators and auditors.
