Q Factors: Quantifying the Qualitative

GULLETTE MICHAELMichael Gullette | Vice President, Accounting and Financial Management |American Bankers Association

Qualitative factors (Q factors) have traditionally involved somewhat of a guessing game. In particular quantifying the factors has been a subjective process. But the landscape has been altered. Auditors are putting more and more emphasis on justifying Q factor adjustments.

In his presentation to the 2016 National ALLL Conference, the ABA’s Michael Gullette discussed Q factors and how to approach quantifying the qualitative. Attendees left  the presentation with a structured approach to Q-factor adjustments and satisfying auditor requirements, under the current incurred loss model and as you move toward estimating your allowance under CECL.

Key Takeaways

  • The underpinnings of both segments and history must be reconsidered.
  • Potential volatility will move management more to quantitative analyses.
  • Lack of directional consistency in metrics will force new/granular metrics.
  • Everything changes, so governance is most important

Q factors are the hard part of today’s allowance practice. They are one of three critical aspects of the ALLL, history and segments being the other two. Management needs to understand Q factors and how they relate to credit risk. Quantifying Q factors is about accounting for credit risk. So we have to look at them holistically, talk more about what that really means. Q factors are judgmental, but they must be directionally consistent with the loss provision. The purpose of Q factors is to adjust historical rates for the difference between conditions that have existed over the measurement period to the measurement date. You must always look at your Q factors in relation first to the two other aspects of the ALLL estimate. If we can quantitatively or analytically support what we can support, then the questions over the judgmental stuff get a lot easier to answer.

When I look at the Q-factor list from the 2006 guidance or SAB 102, it looks like there are four major factors: lending policies, nature of the portfolio, collateral and concentrations. I think most small community banks apply those factors to the segments that are generally those used in call reports. Those Q factors are no longer Q factors if you’ve taken those parts of the portfolio and broken them into a different segment. Maybe you don’t have the data to do that; it requires more granular data than you might keep. It also requires a governance process to evaluate the legitimacy of the segments. But if you figure those out, your Q-factor adjustments should be minimal – relatively – especially compared to not breaking them out.

When looking at history, in the spirit of trying to increase our efforts over the quantitative in order to minimize the qualitative, we can break history out between loss emergence period (LEP) and loss accumulation period (LAP). The LEP is an attempt to quantify how long it takes before a charge-off event (the culmination of a loss), the loss event happens. As to the LAP, there are guidelines from some auditing firms that the LAP should not be shorter than the LEP. The guiding principle is that if it is longer than the LEP, the more you will have to make up for that difference by adding a Q factor adjustment. And my point here is that you want to minimize the impact of the Q factor wherever you can. Q factors have a different meaning under CECL. Their purpose will be to adjust rates for the difference between the history and not just the measurement date as we do now, but to the end of the contractual term of the loan.

They have a different meaning under CECL because they have a meaning that speaks to a forecast of the future. We need to analyze these impacts because they could create different credit risk characteristics that either require a Q-factor quantitative impact or require separate segmentation.

The biggest Q factor challenges under CECL will be how we factor in our forecasts of future economic conditions and other drivers of credit risk. Over the next several years, banks will likely coalesce around similar sources of where the forecasts come from. You’re going to be reporting delinquency and nonaccrual metrics that will often contradict the direction of your provisions. The quantitative nature of what is currently happening in the economy and what is currently going on with collateral or with past due loans is pretty much irrelevant.

In review, under CECL:

  • The underpinnings of both segments and history must be reconsidered.
  • Potential volatility will move management more to quantitative analyses.
  • Lack of directional consistency in metrics will force new/granular metrics.
  • Everything changes, so governance is most important.

Listen to the full audio of the presentation with slide deck.

Download the full 2016 National ALLL Conference Digest.