July 2024

ACL Model Validation

Part III: Qualitative Adjustments

By: Peter Warmenhoven, Consultant

As previously mentioned in Part 2 of this ACL Model Validation series, financial institutions have recently transitioned to the new Current Expected Credit Loss, or “CECL” method of estimating the Allowance for Credit Losses (“ACL”). While much about the CECL method is unfamiliar, and while ACL calculation models vary, there are a few basic similarities with the previous incurred-loss method. First, historical loss information still provides the starting point and figures heavily into the “quantitative” calculation of an institution’s ACL.

Further, the CECL method still incorporates adjustments for qualitative and environmental factors into the ACL calculation, to adjust for how current or forecasted conditions differ from historical loss experience. The purpose of qualitative factors is to adjust for what is not in the historical loss analysis. An important difference with CECL is that management should apply a forward-looking thought process when evaluating these criteria.  Q-factor adjustments should address the differences in the current environment, and the current or expected conditions that indicate that future loss rates will be different than losses incurred in the past.

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