Comptroller Dugan Views Accounting for Loan Loss Reserves as Procyclical

Current accounting for loan loss is procyclical by forcing banks to build reserves when it is most difficult to do so, said Comptroller of the Currency John C. Dugan. In remarks at the Institute of International Banking, he urged a more counter-cyclical approach that would allow provisions to be made earlier in the credit cycle, when times are good.

Current accounting standards for loan loss provisioning are based on the incurred loss model under which a bank can make a provision to the reserve only if it can document that a loss has been incurred, which means that a loss is probable and can be reasonably estimated. The easiest way to document those conditions is to refer 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, it becomes difficult to use acceptable documentation based on history and recent experience to justify significant provisioning. Thus, when bankers were unable to produce acceptable documentation, noted the OCC chief, auditors began to lean on them to reduce provisions or even take the more extreme step of reducing reserves. The result, he said, was that the industry went into the current downturn without adequate reserves to absorb the wave of loan losses that are now being recognized.

Regulators must do a better job telling banks and their auditors the degree to which they are permitted to use non-historical, forward-looking judgmental factors to justify provisions to the loan loss reserve, he said. Regulators should also clarify that the documentation requirements for doing so are not a case of what the Comptroller called ‘`mission impossible.’’

In addition, disclosure of bank reserve methodology and practices should be more robust. If banks believe they need more flexibility to use their expert judgment to recognize losses in the credit cycle, he reasoned, then that judgment should be able to withstand the glare of investor scrutiny as an important check on the process.

Mr. Dugan said that current regulatory rules, which limit the use of reserves in Tier 2 capital to 1.25 percent of risk-weighted assets, should be revised to remove disincentives to building reserves. Further, the Comptroller said changes to the incurred loss model itself may be needed. He believes that there are particularly strong arguments for a more forward-looking life of the loan or expected loss concept, where permissible provisions would focus on losses expected over a more realistic time horizon, and would not be limited to losses incurred as of the balance sheet date, as under the current regime.

The Comptroller noted that a Financial Stability Forum working group, which he co-chairs with SEC Commissioner Kathleen Casey, is exploring a number of questions with respect to reserves. He said that the work of this group will help inform the work of standard setters, regulators, and policy makers in this area.

Regulators should recognize the fact that, where quarterly losses are caused by reserve-building, that is a positive not a negative net result. 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.

He acknowledged that some regulators have never met a loan loss reserve that was large enough, adding that they often press for higher reserves than the accountants and bankers would like. At the same time, the OCC understands the traditional concerns of the accounting standard setters that, without strict adherence to the incurred loss model, banks might use the proverbial cookie jar of loan loss reserves to manage earnings over time, and in particular, to make unexpected losses look less bad to investors. If distorted in this manner, the loan loss reserve would impair transparency and reduce market discipline, and would also be unacceptable to both securities and banking regulators.

The Comptroller questioned whether a slavish adherence to a cramped interpretation of the incurred loss model is really necessary to prevent unlawful earnings management. For example, disclosure could be enhanced to constrain this practice.

If the issue with earlier-in-the-cycle loan loss reserving is ultimately one of transparency, he noted, then more robust disclosure of bank reserving methodology and practices is one straightforward measure for providing an accurate picture to investors. Another constraint is continual scrutiny by regulators to make sure that the loan loss reserve is not being abused for purposes other than appropriate loss recognition.

More broadly, he questioned the current incurred loss model itself. There is a strong argument for more forward-looking life of the loan or expected loss concept, where permissible provisions would focus on losses expected over a more realistic time horizon, and would not be limited to losses incurred as of the balance sheet date, as under the current regime.

Some commenters have pointed to the dynamic provisioning model that has been used in Spain to permit more mechanical increases to loan loss reserves based on loan growth rather than measures of projected loss. While the OCC needs more details about how the dynamic provisioning approach actually works in practice, and whether it can really be squared with the fundamental concept of loss recognition, the model has the initial appeal of creating greater reserves earlier in the cycle. Still others have suggested eliminating accrual accounting altogether and moving to fair value accounting for all bank assets as a way to address this issue. While the Comptroller disfavors that approach because it would produce even more pro-cyclicality, he wants to hear all ideas as part of a vigorous debate to improve the current standard.