In early 2020, due to the COVID-19 pandemic, credit unions, along with the rest of the world, saw threats to safety and soundness. Not only financial security and soundness, but threats to physical security and soundness. The response from credit unions has been manifold. The first step was to ensure the physical security of members and staff. Then he looked after the financial needs of the members, which took shape by offering extensions and / or short-term financing to consumers and guaranteeing paycheck protection loans for commercial members. Once the members were served, it was time to examine the impacts on financial statements and loan loss reserves.
In 2020, credit unions began building their allowance for loan losses by making an additional allowance for loan losses. As a result, the credit union loan loss allowance has increased from approximately 0.86% of loans as at December 31, 2019 to approximately 1.11% of loans as at December 31, 2020.
As credit union reserves grew, delinquencies and write-offs declined. The load-off ratios went from 67 bps to 56 bps and the delinquency went from 68 bps to 59 bps.
It has been over a year since the economy was rocked by the COVID-19 pandemic. The dust started to settle and the economies started to reopen. While some uncertainty remains, it is starting to become more likely that the impacts on credit union losses will be less than expected.
Most finance professionals agree that a conservative allocation in times of uncertainty is appropriate. However, credit unions are now wondering how they should manage their allowance for loan losses in a post-COVID environment. Should they start reducing their reserves, or should they continue to build reserves against the upcoming current expected credit loss (CECL) rules? If they choose to start reducing their reserves, is it appropriate to credit an allowance for loan losses, or better to allow written off loans to erode reserves?
As the CPA and President of 2020 Analytics, which has worked with credit unions for over 10 years, I understand that the decision is complex. The allowance for losses on loans and rentals is the most important estimate on your balance sheet and requires professional judgment.
First, from a technical accounting point of view, credit unions should do not consider the future implementation of the CECL in their determination of the reserves induced by the losses suffered. It is simply not appropriate. From a practical standpoint, credit unions may continue to hold conservative reserves, but these should be supported by reasonable and justifiable qualitative adjustments under current generally accepted accounting principles.
Now is the time for credit unions to assess the status of their allocation.
Because they are generally based on consistent and objective information, reserves for loans under FAS 5 (homogeneous loan pools) are probably appropriate. In addition, loans booked individually under FAS 114 are relatively straightforward, although credit unions should take into account the current state of collateral markets when determining reserves. If you reconsider the relevance of your reserve at the end of the pandemic, your qualitative and environmental (Q&E) adjustments are probably the starting point.
Take into account changes in the quality of credit and collateral in your portfolio, including defaults. You can also reconsider subjective reservations related to the pandemic, either arbitrarily or related to economic indicators like unemployment.
According to the Bureau of Labor Statistics, unemployment rates fell to 5.8% in May 2021 from a peak of 14.8% in April 2020. If you create a qualitative and environmental reserve by assuming the number of 14.8 % would hold up in the long run, your Q&E reserves probably need some adjustment.
The degree to which you are overrated and the approach you might take to adjusting your reserves requires the most professional judgment. I hesitate to say that we are completely out of the woods at this point. Many borrowers who have suffered severe financial repercussions as a result of the COVID-19 pandemic have continued to receive assistance. Additionally, special credit scoring codes put in place by the Consumer Data Industry Association have protected borrowers’ credit scores from downward migration due to financial hardship related to the pandemic.
To smooth out the impact on the income statement of a large one-time adjustment while maintaining a layer of caution in case we see delayed impacts from the pandemic, I suggest comparing your current allocation (point A) to the place where your allowance could be if we hadn’t affected it by this pandemic (Point B). Consider reducing your qualitative reserves from point A to point B over a reasonable period (such as 12 months) if we do not have any economic surprises during that period. For some credit unions this means that a credit will have to be charged to the allowance for loan losses, which would be appropriate if it is justifiable.
Your allowance for loan losses is an estimate. Assuming your COVID-19 loan loss estimates were reasonable and supportable, saying that your qualitative adjustments were too high in retrospect is not an admission that your historical reserves were inappropriate. However, continuing to maintain these reserve levels when more positive economic conditions arise may be.
Dan Price, CPA, CFA is President of 2020 Analytics, a loan portfolio analysis provider based in Clearwater, Florida.