Testimony of Governor Laurence H. Meyer
Loan loss reserves
Before the Subcommittee on Financial Institutions and Consumer Credit, Committee on Banking and Financial Services, U.S. House of Representatives
June 16, 1999
Attachment to the Testimony
Response to questions in June 8, 1999 letter to Chairman Greenspan from the Honorable Marge Roukema, Chairwoman, Subcommittee on Financial Institutions & Consumer Credit
The banking agencies' policy for loan loss allowances is set forth in the December 1993 Interagency Policy Statement on the Allowance for Loan and Lease Losses. The guidance set forth in this policy statement is consistent with GAAP. In this regard, senior officials of the SEC and FASB reviewed the policy statement for its consistency with GAAP prior to its issuance. Furthermore, the November 1998 policy statement of the banking agencies and SEC reiterates that this policy statement is consistent with GAAP.
The Federal Reserve's staff includes a number of professionals that are knowledgeable of bank accounting principles and that are Certified Public Accountants (CPAs). When questions arise pertaining to the consistency of bank policies with GAAP, these professionals are consulted. Furthermore, CPAs in the Federal Reserve Board's staff in Washington maintain close contact with accounting policy representatives of the other banking agencies, SEC, FASB, and AICPA. Periodic meetings are held with accounting policy representatives of these agencies. Moreover, when particular questions arise regarding the interpretation and application of GAAP, Federal Reserve staff members often consult with representatives of the SEC, FASB, and AICPA.
As part of a safety and soundness examination, examiners review the adequacy of a bank's loan loss reserves in accordance with the December 1993 Interagency Policy Statement. Such examinations occur at least annually or, for certain banks with less than $250 million in assets, every 18 months. As noted above, the 1993 policy statement is consistent with GAAP. As set forth in the policy statement, institutions and examiners should consider a number of factors in assessing the adequacy of their reserves, including comparisons to peer group averages and local and regional economic trends and conditions.
Due to our safety and soundness responsibilities, the Federal Reserve encourages institutions to maintain prudent and conservative allowance levels. Our examiner guidance does not direct institutions to increase their reserves beyond amounts that are permitted under GAAP or that are not warranted by bank or bank supervisory analysis. While we encourage banks to continually review their loan loss reserve levels in relation to the risks in the loan portfolio, it is not our policy to "always encourage" institutions to increase their reserves.
In general, the SEC has not coordinated its comments on loan loss reserves of specific institutions with the Federal Reserve, although they have discussed significant situations involving individual institutions with us on a case-by-case basis. We believe that consultation by the SEC with the federal banking regulators prior to issuing loan loss reserve comments would promote a more consistent application to reserves under GAAP. Such communication is particularly important given our different missions.
Currently, overall reserves in the banking industry seem generally consistent with historical levels relative to past exposures, and we believe that risks to the banking system have not declined. Indeed, a strong case could be made that risks and uncertainties have increased. Accordingly, we do not believe there is a widespread problem.
Given the level of judgment involved in identifying appropriate allowances, it is important to bear in mind past experience and the dynamic nature of banking markets today. The experience of the 1980s and early 1990s underscored for both bank management and bank regulators the need to maintain a strong and prudent level of reserves. Indeed, in recent years, financial markets, analysts, and regulators have encouraged banks to maintain conservative reserve levels - not levels intentionally set too high, but that reflect the amount of losses that history indicates is inherent in extending credit. What may appear to be "excessive" now, with benefit of hindsight, largely reflects attempts by banks to be conservative and prudent in their assessments of probable losses in a rapidly evolving and uncertain global financial market.
In this time period, the SEC and shareholders were bringing actions against bank holding companies for allegedly deficient disclosures of problem loans and inadequate loan loss allowances, and some of these actions involved claims of securities fraud. During this same time period, the Federal Reserve was taking numerous enforcement actions against bank holding companies addressing, among other things, deficiencies in the loan loss reserve procedures of the companies and their subsidiary banks, many of which were supervised by another bank regulator. In appropriate circumstances, the Federal Reserve issued cease and desist orders and executed formal written agreements requiring bank holding companies to review and revise, as necessary, the standards and practices used by the companies and their subsidiary banks in establishing their loan loss allowance. These actions were undertaken by the Federal Reserve in fulfillment of its obligation to ensure that the bank holding companies operated in a safe and sound manner and consistent with applicable banking laws.
The shares of some of the bank holding companies that were the subject of the Federal Reserve's enforcement actions were publicly held and were also the subject of enforcement actions filed by the SEC or shareholder lawsuits.
In response to concerns about reserve adequacy in the early 1990s, the banking agencies developed the 1993 interagency policy statement on loan loss allowances. The agencies provided drafts of the policy statement to the SEC and FASB and incorporated comments received from them. The SEC and FASB indicated to the banking agencies that the guidance contained in the policy statement was consistent with GAAP.
With respect to the first question, see answer to number 7 above. In the early 1990s, there were significant concerns about the adequacy of accounting standards for loan loss reserves and of banking industry loan loss reserves. Also there was concern that inadequate loan loss reserving practices could overstate bank capital ratios and diminish the effectiveness of prompt corrective action measures. In response to these concerns, the Federal Reserve and the other federal banking agencies issued the 1993 interagency policy statement on loan loss reserves. Due to this policy statement and other factors, the adequacy of bank loan loss reserves has increased significantly since the early 1990s.
Over this time period, Federal Reserve staff had many discussions with the SEC on accounting issues of mutual interest, including loan loss reserves, fair value accounting, accounting for securities, derivatives accounting, market risk, and internal audit outsourcing. The Federal Reserve hosted the SEC's Chief Accountant and other senior SEC accounting policy representatives on a number of occasions over this time period, and also attended meetings of senior accounting policy representatives held at the SEC. Furthermore, when specific accounting issues arose, the federal banking agencies consulted on many occasions with the SEC and FASB staffs.
This question is addressed in the body of the testimony.
The FASB developed Statement No. 114, subject to oversight from the SEC. The banking agencies had a strong interest in the development of Statement 114 and provided comment letters to the FASB.
The banking agencies indicated significant concerns to the FASB regarding the inherent imprecision in estimating both the timing and amount of future cash flows on certain impaired loans, such as commercial credits. These comments are consistent with the banking agencies' views that loan loss reserve estimates are highly judgmental and imprecise, and thus should be estimated in a conservative manner. The banking agencies suggested that the standard should be limited to loans that have reasonably estimable cash flows. While FAS 114 was not amended to reflect this comment, FASB was responsive to certain other comments provided by the agencies.
This question is addressed in the body of the testimony.
As indicated in the body of the testimony, we believe that an expected loss approach may enhance the quality of reserves estimates in comparison to the inherent loss approach that is now promulgated in GAAP. The expected loss approach is more consistent with evolving credit risk management techniques used by many financial institutions.
According to the SEC's announcement, the transition adjustment would apply to institutions with allowance levels that are materially affected by the FASB article. The Federal Reserve's guidance in SR 99-13 provides helpful background information that is intended to assist institutions and their auditors in understanding the SEC announcement and the FASB article in the broader context of other accounting initiatives underway and emerging points of agreement between the SEC and the Federal Reserve on allowance accounting matters. In this regard, the guidance is intended to convey our understanding that the agreement reached on March 10th is intended to maintain existing acceptable allowance practices during the period over which we work to resolve these issues with the SEC and the accounting profession. Accordingly, we believe that changes in allowance levels, if any, as a result of the FASB guidance will be substantially limited.
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