U.S. Comptroller of the Currency: Change Banks’ “Incurred Loss” Model

U.S. Comptroller of the Currency John Dugan said the “incurred loss” model banks use to account for loan losses may need to be changed to a more counter-cyclical approach that would allow provisions to be made earlier in the credit cycle when times are good.

Dugan, who is the administrator of national banks and chief officer of the Office of the Comptroller of the Currency, urged changes to the current accounting model for loan losses in remarks during the annual meeting of the Institute of International Bankers on March 2 in Washington.

“Perversely, as the banking industry experienced a prolonged period of rising and record profits in the booming part of the economic cycle in the earlier part of this decade, the ratio of loan-loss reserves to total loans went down, not up—even though there was broad recognition that the cycle would soon have to turn negative,” he said.

Dugan said that under the incurred loss model, a bank can make a provision to reserves only if it can document that a loss has been “incurred,” meaning the loss is probable and can be reasonably estimated. The easiest way to document those conditions is by referring to historical loss rates and the bank’s own prior loss experience with the type of asset in question.

In a long period of benign economic conditions, recent history becomes a difficult basis of acceptable documentation. Without acceptable documentation, Dugan said, auditors leaned on bankers to reduce provisions or even reduce reserves, resulting in so-called “negative provisioning.” As a result, the industry entered the current downturn without adequate reserves to absorb the losses now being recognized.

Banks and their auditors need to know the degree to which nonhistorical, forward-looking judgmental factors can be used to justify provisions to loan-loss reserves, Dugan said. He suggested changes in the incurred loss model itself may be needed, such to a more forward-looking “life of the loan” or “expected loss” concept.

Dugan also said current regulatory rules that limit the use of reserves in Tier 2 capital to 1.25% of risk-weighted assets should be revised to remove disincentives to building reserves. Provisions banks have made recently, while a drag on earnings, he said, have not only offset current charge-offs, but have built reserves to substantially higher levels that will help with future loan problems.

“We ought to be talking about capital and reserves, and we ought to be recognizing the fact that, where quarterly losses are caused by reserve-building, that’s a net result that is positive, not negative,” Dugan said. “When a bank takes a loss to build a reserve, it is appropriately recognizing problems that they will see on the horizon, which is all to the good.”

Dugan’s complete remarks are available at www.occ.treas.gov/ftp/release/2009-16a.pdf.