How do adjustment factors (so-called Q factors) change under CECL?

On March 13, 2018, some of MST’s advisory group teamed up to offer their thoughts in a webinar entitled, “Key Issues and Trends in CECL Transition: A Panel Q & A Webinar.” In this Q & A style webinar, MST Senior Advisors Paula S. King, Garry Rank, and Dorsey Baskin answered questions moderated by Regan Camp. This panel of allowance experts from MST Advisory Services answered questions and shared the key issues and trends in preparation and transition to CECL for financial institutions from their hands-on experience. They all have been intimately involved in studying the allowance both in its incurred loss form as well as what we can expect from the expected credit loss estimation.

This is the first in a series of questions and answers from the webinar.

Question:

How do adjustment factors (so-called Q factors) change under CECL?

Answer:

This answer should be prefaced by first reminding all that adjustment factors (qualitative and quantitative) have one and only one purpose –

Adjustment factors are needed to adjust the average charge-off rates calculated over a historical charge-off accumulation period for the differences between:

1. The conditions that existed when the loss-causing events were occurring that resulted in the charge offs captured in the accumulation period, and
2. The conditions expected during the expected life of a pool of loans.

Thus, adjustment factors are a consequence of the use of that average historical charge-off rates to estimate losses over a future period that likely will be subject to different (and changing) economic, loan underwriting and/or loan servicing conditions than existed during the historical period.  Adjustment factors have no other purpose if used in a manner consistent with GAAP.

So, what’s new under CECL:

1. The loss (charge off) accumulation period changes from an arbitrary number of years or quarters to a period that covers the lives of historical pools of loans
   • Depending on lives of the pools, this may be longer than has been used in the past, thus, it would be capture the charge offs resulting from more different and changing conditions.
   • Adjustment factors will need to be “adjusted” for this change. And as an unfortunate consequence of this change to expected losses, correlations between past conditions and observed losses may or may not be as strong.
2. The adjustment factor(s) applied under CECL will need to be based on forecasted future conditions rather than on recently observed actual conditions.

To access a recording of the webinar, click here.