At the beginning of 2020, because of the COVID-19 pandemic, credit unions along with the rest of the world, saw threats to safety and soundness. Not only financial safety and soundness but threats to physical safety and soundness. The response at credit unions was multi-faceted. First it was ensuring the physical safety of members and staff. Then it was tending to the financial need of members, which took shape by providing extensions and/or short-term funding to consumers and securing Paycheck Protection Loans for business members. Once the members were served, it became time to consider the impacts to financial statements and loan loss reserves.
In 2020 credit unions began building up their allowance for loan loss reserve by taking additional provision for loan loss expense. As a result, allowance for loan losses at credit unions rose from approximately 0.86% of loans as of December 31, 2019 to approximately 1.11% of loans as of December 31, 2020.
As reserves at credit unions were increasing, delinquency and charge offs were falling. Charge off ratios fell from 67 bps to 56 bps and delinquency fell from 68 bps to 59 bps.
It’s been over a year since the economy was shaken by the COVID-19 pandemic. The dust has begun to settle and economies have begun reopening. While some uncertainty remains, it is starting to become more likely that the impacts to credit union losses will be less than expected.
Most financial professionals agree that a conservative allowance in the face of uncertain times is appropriate. However, now credit unions are asking how they should manage their allowance for loan loss reserve in a post-COVID environment. Should they begin reducing their reserves, or should they continue to build reserves in the face of the upcoming Current Expected Credit Loss (CECL) rules? If they choose to begin reducing reserves, is it appropriate to credit provision for loan loss expense, or better to allow loans charged off to erode away reserves?
As a CPA and President of 2020 Analytics working with credit unions for over 10 years, I understand the decision is a complex one. The allowance for loan and lease loss reserve is the most significant estimate on your balance sheet and requires professional judgment.
First, from a technical accounting perspective, credit unions should not consider future CECL implementation in their determination of incurred loss driven reserves. It’s simply not appropriate. From a practical standpoint, credit unions may continue to carry conservative reserves, but these should be supported by reasonable and supportable qualitative adjustments under current Generally Accepted Accounting Principals (GAAP).
Now is the time for credit unions to assess the state of their allowance.
Because they’re typically based on consistent and objective information, reserves for loans under FAS 5 (homogenous loan pools) are likely appropriate. Additionally, loans individually reserved for under FAS 114 are relatively straight forward, although credit unions should consider the current state of collateral markets in their determination of reserves. If you’re reconsidering the appropriateness of your reserve as we emerge from the pandemic, your qualitative and environmental (Q&E) adjustments are likely the place to start.
Dan Price
Originally published in Credit Union Times June 18, 2021.
