OPINION
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November 16, 2012, 6:52 p.m. ET
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Banks Need Long-Term Rainy Day Funds
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Accounting rules prevent banks from building loss reserves until shortly before a bad loan is actually written off. That's just too late.
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By EUGENE A. LUDWIG
AND PAUL A. VOLCKER
Governments around the world are taking bold steps to minimize the likelihood of another catastrophic financial crisis. Regulators and financial institutions already have their hands full, so the bar for adding anything to the agenda should be high.
However, one relatively simple but critically important item should move to the top of the list: reforming the accounting rules that inexplicably prevent banks from establishing reasonable loan-loss reserves. If reserve rules had been written correctly before 2008, banks could have absorbed bad loans more easily, and the financial crisis probably would have been less severe. It is now time, before the next crisis, to recognize that reality.
Loan-loss reserves get far less attention than capital or liquidity requirements, which are subject to specific government regulations. Nevertheless, the "Allowance for Loan and Lease Losses" should be an essential part of assessing the safety and soundness of any bank. The ALLL—not Tier 1 capital or even cash-on-hand—is the most direct way a bank recognizes that lending, including necessary and constructive lending, entails risk. Those risks should be recognized in both accounting and tax practices as a reasonable cost of the banking business.
However, banks are now only allowed to build their loan-loss reserves according to strict accounting conventions, enforced by the Securities and Exchange Commission. Reserves have to be based on losses that are strictly "incurred," in effect shortly before a bad loan is written off. Bankers have been prohibited from establishing reserves based on their own expectations of future losses.
The practical result is that in good times real earnings are overrated. Conversely, the full impact of loan losses on earnings and capital is concentrated in times of cyclical strain.
Why have accounting conventions created this perverse result? Some accountants claim that giving banks flexibility with their reserves is bad because it lets bankers "manage earnings"—that is, to raise or lower results from quarter to quarter to look better in investors' eyes. This is a weak argument, because the ALLL reflects a banking reality, and the allowance itself is completely transparent.
No one is misled when sufficient disclosures exist. The size of the bank's reserve cushion will be on the balance sheet, and it would need to be recognized as reasonable by auditors, supervisors and tax authorities.
Importantly, from a financial policy point of view, reserves will tend to be countercyclical, likely to discourage aggressive lending into "bubbles" but helping to absorb losses in times of trouble.
Capital is vital to the safety and soundness of banks. It is the ultimate and necessary protection against insolvency and failure.
However, permitting a more flexible allowance for loan-loss reserve, an approach that gives banks and prudential regulators the right to exercise reasonable discretion to build a more flexible cushion in case of loss, is a must. Accounting rules need to change to permit this to happen.
Mr. Ludwig, the CEO of Promontory Financial Group, was Comptroller of the Currency from 1993 to 1998. Mr. Volcker, former chairman of the Federal Reserve System, is professor emeritus of international economic policy at Princeton University.
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However, one relatively simple but critically important item should move to the top of the list: reforming the accounting rules that inexplicably prevent banks from establishing reasonable loan-loss reserves. If reserve rules had been written correctly before 2008, banks could have absorbed bad loans more easily, and the financial crisis probably would have been less severe. It is now time, before the next crisis, to recognize that reality.
Loan-loss reserves get far less attention than capital or liquidity requirements, which are subject to specific government regulations. Nevertheless, the "Allowance for Loan and Lease Losses" should be an essential part of assessing the safety and soundness of any bank. The ALLL—not Tier 1 capital or even cash-on-hand—is the most direct way a bank recognizes that lending, including necessary and constructive lending, entails risk. Those risks should be recognized in both accounting and tax practices as a reasonable cost of the banking business.
However, banks are now only allowed to build their loan-loss reserves according to strict accounting conventions, enforced by the Securities and Exchange Commission. Reserves have to be based on losses that are strictly "incurred," in effect shortly before a bad loan is written off. Bankers have been prohibited from establishing reserves based on their own expectations of future losses.
The practical result is that in good times real earnings are overrated. Conversely, the full impact of loan losses on earnings and capital is concentrated in times of cyclical strain.
Why have accounting conventions created this perverse result? Some accountants claim that giving banks flexibility with their reserves is bad because it lets bankers "manage earnings"—that is, to raise or lower results from quarter to quarter to look better in investors' eyes. This is a weak argument, because the ALLL reflects a banking reality, and the allowance itself is completely transparent.
No one is misled when sufficient disclosures exist. The size of the bank's reserve cushion will be on the balance sheet, and it would need to be recognized as reasonable by auditors, supervisors and tax authorities.
Importantly, from a financial policy point of view, reserves will tend to be countercyclical, likely to discourage aggressive lending into "bubbles" but helping to absorb losses in times of trouble.
Capital is vital to the safety and soundness of banks. It is the ultimate and necessary protection against insolvency and failure.
However, permitting a more flexible allowance for loan-loss reserve, an approach that gives banks and prudential regulators the right to exercise reasonable discretion to build a more flexible cushion in case of loss, is a must. Accounting rules need to change to permit this to happen.
Mr. Ludwig, the CEO of Promontory Financial Group, was Comptroller of the Currency from 1993 to 1998. Mr. Volcker, former chairman of the Federal Reserve System, is professor emeritus of international economic policy at Princeton University.
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