Revamp Would Help Banks Boost Reserves

Provision Seeks to Avert Thin Capital Cushions That Helped to Worsen the Financial Crisis By MATTHIAS RIEKER Tucked into the Treasury Department's proposed regulatory overhaul is a push for banks to salt away more money for losses when times are good. It is a matter dear to bankers and their primary regulators. For more than a decade, banks have been restricted by accounting standards and the Securities and Exchange Commission from building capital reserves for loan losses that are likely to occur but difficult to predict. "Banks felt under pressure to keep reserves thin," said Eugene Ludwig, the former comptroller of the currency who now heads consulting firm Promontory Financial Group LLC. The restrictions worsened the financial crisis for banks. The reserves they set aside during good times didn't cover their losses during the financial crisis, and banks had to scramble for capital. Last week's proposal by the Obama administration includes a provision that could help avert a repeat of the problems. "We recommend that the accounting standard setters improve accounting standards for loan-loss provisioning by the end of 2009," the Treasury said in the financial-overhaul plan. Bankers hold capital reserves mainly for loans to borrowers who are delinquent, or whose default is probable. That restriction means bank earnings get hit with rising loan-loss provisions in bad times, usually when revenue also declines. Many bankers disapprove of the current rules. J.P. Morgan Chase & Co. Chairman and Chief Executive James Dimon wrote in the bank's annual report, "I find it absurd that loan-loss reserves tend to be at their lowest point precisely when things are about to get worse." Bank of America Corp. CEO Kenneth Lewis told CNBC in April that the current rules make "no sense at all." Mr. Ludwig said bankers "ought to have maximum flexibility to allow for the judgment of management, provided, of course, everything is transparent to the investor." The International Accounting Standards Board set up an advisory group to review the matter, and the discussion is moving toward allowing banks to reserve for expected losses, similar to the "dynamic-provisioning" rule introduced by the Spanish central bank in 1999. The method is a statistical probability of default calculated for loans when they are made. "From the very moment that a loan is granted, and before any impairment on this specific loan appears, there is a positive default probability, no matter how low it might be," Jaime Caruana, then governor of the Bank of Spain, said in a speech in Chicago in 2002. Dynamic provisioning leads to "sound risk management" and can "moderate cyclical swings," he said. In the U.S., bank regulators such as the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency would like banks to build big loan-loss reserves. But the SEC worries that banks can use loan-loss provisions to smooth earnings. The SEC has tussled twice with regional bank SunTrust Banks Inc. over reserves. In 1998, when SunTrust wanted to make an acquisition, its loan-loss reserve came under SEC scrutiny. At the time, the Atlanta bank held a reserve of $666 million, 1.6% of total loans. The SEC forced SunTrust to reduce its reserve by about $100 million because the agency felt the reserve was too high. In 2004, the SEC took aim at SunTrust again. The bank's assets had doubled, and its loan-loss reserve stood at almost $1 billion, or just above 1% of loans. The SEC criticized the company's assumptions in building the reserve, among other things, and SunTrust fired its chief risk officer. The SEC declined to comment. In the first quarter this year, SunTrust took $650 million in loan losses, and built its loan-loss reserve to 2.3% of loans, to $2.74 billion as of March 31. According to the FDIC, banks reserved $194 billion in the first quarter for loan losses, or 2.7% of total loans. In the first quarter of 2006, the overall reserve was $77.7 billion, or 1.1% of loans. As the real-estate bubble swelled during the next year, the reserve fell slightly. Soon, banks had to play catch-up. Not all bankers wanted to build reserves during good times. John Dugan, head of the OCC, said in a speech in March, "We do frequently find ourselves in the position of pressing for higher reserves than the accountants and bankers would like." Write to Matthias Rieker at matthias.rieker@dowjones.com