Banks Need Long-Term Rainy Day Funds

SATURDAY/SUNDAY, NOVEMBER 17 - 18, 2012
© 2012 Dow Jones & Company, Inc. All Rights Reserved.
Banks Need Long-Term Rainy Day Funds
By Eugene A. Ludwig And Paul A. Volcker
overnments 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
Accounting rules prevent
banks from building loss
reserves until shortly
before a bad loan is
actually written off.
That’s just too late.
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.
The Publisher ’ s Sale Of This Reprint Does Not Constitute Or Imply Any Endorsement Or Sponsorship Of Any Product,
Service, Company Or Organization.
Custom Reprints 800.843.0008 www.djreprints.com DO NOT EDIT OR ALTER REPRINT•/
• REPRODUCTIONS NOT PERMITTED #3032530294516