One subject of much debate since the financial crisis has been what determines how much money banks keep in their reserve accounts to offset losses from loans that default, known as loan loss provisions.
A report from the Federal Reserve Bank of Cleveland written by Constantine Madias and Lakshmi Balasubramanyan discusses the issue of how banks determine their reserve levels for loan-loss provisions. The authors found in the data on U.S. banks covering the last several decades, banks tend to undercontribute to the reserves during periods of prosperity, which forces them to build up reserves during less-than-prosperous economic times.
Rules are in place to prevent bank managers from manipulating the timing (level) of the bank’s reported earnings by using the reserve accounts. The allowance for loan and lease losses (ALLL), which is the balance of the reserve account, does not impact the bank’s earnings; however, reported earnings are reduced when banks engage in a practice known as loan-loss provisioning, which is adding to the reserve account. As a result of the earnings being reduced, the shareholders’ equity is also reduced.
“The accounting profession prefers this approach because it produces financial statements that reflect companies’ current situations more accurately,” the authors stated. “But financial regulators, who are more focused on the safety and soundness of banks, prefer an approach that helps banks accumulate an adequate supply of reserves before they are needed.”
The authors noted that the typical scenario for economic downturns is for the number of problem loans to rise, along with loan-loss provisions. During the financial crisis of 2008 and 2009, commonly known as the Great Recession, net charge-offs totaled more than $50 billion, a historically high level. Meanwhile, the provisions for loan and lease losses more than tripled from 2007 to 2008 at the onset of the recession—from less than $20 billion to more than $70 billion in just a year.
“In all likelihood, banks were increasing their loan-loss provisions at a time when it was more difficult and costly for them to do so.”
“In all likelihood, banks were increasing their loan-loss provisions at a time when it was more difficult and costly for them to do so,” the authors said.
The authors compared the numbers on loan-loss provisions, which are a bank’s expectations of future loan losses, with net charge-offs, which are actual losses, from three different periods and found that the elevated level of loan-loss provisions as a percentage of net charge-offs during the 2008 crisis (187 percent) was still well below the ratio during the savings and loan crisis from the mid-1980s until the mid-1990s. The ratio of loan-loss provisions as a percentage of net charge-offs in 1987 during the middle of that crisis was well above 500 percent, according to the authors. By comparison, in the 10 years prior to the 2008 crisis, the ratio averaged 110 percent.
The authors announced that new rules for loan-loss provisioning by the Financial Standards Accounting Board (FASB) are currently in the works.
“The old approach (incurred loss), which does not allow banks to recognize loan losses until the actual default has occurred, will be replaced with a forward-looking, expected loss approach,” the authors wrote. “While the size of the losses will not likely change, the timing of their appearance on the balance sheet will. The new expected loss approach will entail more discretion on the part of bank managers.”