Banking / Financial Reporting

Washington Furor Over Loan Loss Reserves

Are banks with generous loan loss reserves practicing conservative accounting or earnings manipulation? That’s the heart of a Washington, D.C., brouhaha that prompted a House subcommittee to hold a heated hearing on accounting for loan loss reserves.

The differences between groups on both sides of the issue are subtle. However, disagreements on emphasis, timing and exactly where to draw the line could have important consequences for banks operating in a volatile world economy. Historically, banks have gotten into trouble when they failed to build up allowances for loan losses in prosperous times. As a result, regulators have smiled on increases in reserves within the restrictions imposed by GAAP, considering them to be appropriately conservative accounting.

The U.S. economy has been riding a drawn-out cyclical crest for some time now. Nonetheless, the SEC, which has been conducting an independent campaign against earnings manipulation, has chosen this time to warn banks against padding loan loss reserves. The commission is concerned that loan loss reserves potentially could be used to smooth earnings. This might be particularly tempting if implementation of FASB no. 133, Accounting for Derivative Instruments and Hedging Activities, causes bank earnings to swing erratically, as it is expected to. The SEC first drew attention to its thinking on allowances for loan losses last year when it delayed the acquisition of Crestar Financial Corp. by SunTrust Banks Inc. until Sun took a one-time reduction in its loan loss reserves.

The issue became even more inflammatory last May, when the Federal Reserve Board (the Fed) surprised other bank regulatory agencies and the banking industry by apparently ratifying the SEC’s stand. The Fed issued guidance to financial institutions on FASB Viewpoint no. 126-B, “Application of FASB Statements 5 and 114 to a Loan Portfolio,” which had been published April 12. Although the Fed’s guidance explicitly allowed for the possibility that banks might still legitimately increase their allowances for loan losses under GAAP, it was not seen that way by the banking industry.

That reaction to the Fed’s endorsement of FASB’s staff-written implementation paper was fueled by language expressly stating that a creditor may not “simply increase (or not decrease) the allowance for loan losses in ‘good’ economic times to provide for losses expected to occur in the future.” Nonetheless, the FASB paper does leave some “wiggle room” when evaluating smaller loans as a group under Statement no. 5 or a group of loans with risk characteristics in common.

The Fed’s guidance led bankers and bank regulators to worry that it, albeit indirectly, was encouraging reductions in allowances for loan losses at a point in the business cycle when prudence dictates such reserves should be increasing. The banking industry turned to legislators for help, and the House consequently held its hearing.

On June 16, the House Banking and Financial Services Committee’s Subcommittee on Financial Institutions and Consumer Credit heard testimony on accounting for loan loss reserves. Representatives of the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS) and Robert Morris Associates (RMA), a banking industry association, all were distressed that the FASB paper, and the SEC’s concerns with excessive reserves, sent the wrong signal to banks. Both Democratic and Republican subcommittee members loudly voiced support for the group, as did other representatives of the banking industry.

Summing up the banking industry’s ire over the timing of the SEC’s moves, RMA President Allen Sanborn testified, “I believe that we are in what I would characterize as the ninth year of a seven year economic cycle….For the SEC to begin questioning reserves at this point in the business cycle is, fundamentally, very bad public policy.”

SEC General Counsel Harvey Goldschmid argued that the SEC does not want banks to “artificially lower loan loss reserves”—it merely wants them to comply with GAAP. Goldschmid held that, consistent with the SEC’s broader concerns about transparency issues, it believes excessive loan loss reserves obscure investors’ ability to detect imminent problems. If banks are worried about a volatile economy, the SEC would prefer to see them increase their capital, not their loan loss reserves.

All sides agree that banking institutions should be following GAAP, but the relevant principles—in FASB statements no. 5 and no. 114—could be made clearer. The AICPA has organized an eight-member task force on accounting for loan losses. The task force, chaired by Pricewaterhouse Coopers partner Martin F. Baumann, has set up a schedule to resolve several fuzzy issues, including the distinction between current and future losses; how to reconcile application of FASB Statements no. 114, Accounting by Creditors for Impairment of a Loan, and no. 5, Accounting for Contingencies ; and acceptable methods for measuring loss incurred—especially whether some of the newer models of credit risk may be used, what disclosure should be required in footnotes to facilitate comparisons between institutions and what documentation should be offered in support of estimated loan losses. The task force’s prospectus has already been approved by AcSEC and comes before FASB for approval on September 8.

According to Baumann, the task force’s mission is “to narrow the boundaries” of what is acceptable under GAAP and, where there is still room for differences, “to enhance the disclosure.” The task force, in consultation with observers from the OCC, the SEC and FASB, plans to issue a proposed statement of position for public comment in August 2000, to be finalized in the second quarter of 2001.

Under the specter of legislative interference implied by the House subcommittee hearing, the government agencies’ joint working group issued a statement listing points of agreement on July 12. The letter, from the SEC, the Fed, the FDIC, the OCC and the OTS, included a quote from SEC chairman Arthur Levitt saying that the commission’s actions should not be interpreted as an indication that it views current loan loss reserves as too high. The joint working group is charged with issuing guidance on disclosure and documentation that will meet the needs of all the government agencies. Its deadline: March 2000.