Calculating loan-loss reserves is getting more dicey.

Credit quality is deteriorating, and estimating the bottom is daunting, yet bankers remain under pressure from auditors to reserve no more than current losses dictate.

Reserves jumped 7% in the third quarter from the year earlier, the largest such increase in the last 18 years, according to the Federal Deposit Insurance Corp. But are reserves growing fast enough? And if the pace does pick up, will the Securities and Exchange Commission renew its campaign against earnings management?

Bankers like James Schreiner, a senior executive vice president at the $15 billion-asset Fulton Financial Corp. in Lancaster, Pa., are adjusting their reserving formulas to prepare for further losses due to an economic downturn while still accommodating auditors.

"Fundamentally the SEC and the accounting industry want your modeling for loan-loss reserves to be quantifiable. You have to be able to justify why you're building those reserves. You can't do it just because you have a feeling things are going to get worse," Mr. Schreiner said. "It has forced us to be more disciplined."

Fulton has taken a proactive approach, factoring in economic data such as vacancy rates, lot absorption rates, length of time properties spend on the market, even consumer and business confidence levels.

"We take into account all those things — forward looking — to say, 'Where are we going? What are the trends?' " Mr. Schreiner said. "What's more important now than looking back is what you foresee."

But other bankers trying to make such a transition are still meeting resistance from auditors.

Vincent Boberski, a senior vice president at the FTN Financial Capital Markets Corp. unit of First Horizon National Corp., who advises companies on how to increase their valuations, said he has heard bankers complain about the challenge of justifying reserves as recently as in the past few weeks. "They felt that auditors were still being strict about not being forward-looking," he said.

Several observers said the challenge of building reserves is greater for small banks and thrifts that might not have the money or the expertise for more sophisticated risk modelling.

For nearly a decade, the SEC has been at odds with bank regulators over reserving levels. The banking agencies generally take a "the more the better" view of reserving, but the SEC has sought to prevent banks from, in effect, stockpiling reserves by tying the reserve level more closely to actual, versus expected, losses.

"The fact of the matter is, many banks wanted to reserve more, and the auditors wouldn't let them," said Richard D. Weiss, an analyst at Janney Montgomery Scott LLC.

For now, banking regulators seem satisfied.

"We saw some very large provisioning start in the third quarter and expect to see more for some period of time," Kathy Dick, the deputy controller of credit and risk management at the Office of the Comptroller of the Currency, said in an interview at a banking conference last week in New York.

Grovetta Gardineer, the managing director for examinations and supervision policy at the Office of Thrift Supervision, said a dramatic depreciation of home values in some parts of the country presents a particular challenge.

"It does hinder the assessment of the loan-loss provision," she said at a conference last week. "We have been seeing very recently that some of these risks come pretty fast. In the third quarter, some institutions made provisions, and within weeks they increased them significantly."

Bankers are reacting to the deterioration in credit quality, Ms. Gardineer said. "As they see those losses coming, they increase the provision."

In an e-mailed statement Monday, the chairman of the Public Companies Accounting Oversight Board, Mark Olson, gave auditors some room to work with bankers as they adjust reserving formulas. He noted that existing rules allow banks to, "under appropriate circumstances, make loan-loss provisions that diverge from recent loss experience."

Despite their recent growth, reserves have failed to keep pace with the rise in noncurrent loans, which increased 12.43% in the third quarter from the year earlier at publicly traded banks, according to Sandler O'Neill & Partners LP.

The industry had $1.05 in reserves for every $1 of noncurrent loans at Sept. 30, the lowest coverage ratio in 14 years, according to the FDIC.

"My sense is that there probably hasn't been a big shift yet in the tough stance taken by the auditors, but that's coming," said Mark Fitzgibbon, an analyst at Sandler O'Neill. "Once the companies start experiencing actual losses, they'll be able to make more plausible arguments for how much they want to put in reserves."

Hanmi Financial Corp. in Los Angeles is one of many banks stuck in the middle. The $4 billion-asset company employed its usual formula, based on loan data from the 10 worst quarters in recent years, to calculate its third-quarter reserves. The result: It quadrupled its reserve, to $8.5 million, compared to the year earlier.

"That's not based on our arbitrary determination," said Sung Won Sohn, the chief executive officer. "That's based on history."

But on an earnings conference call, James Abbott, an analyst at Friedman, Billings, Ramsey Group Inc., asked whether the increase should not have been even bigger. Hanmi attributed only $158,000 of the increased allowance to its $165 million of loan growth — which works out to roughly 10 basis points. "I guess I'll just state for the record that makes me particularly nervous," he said. "History is not likely to repeat itself, given the fact that we have a housing market that is declining."

Though he insists the third-quarter provision was sufficient, Mr. Sohn conceded that Hanmi plans to enhance its formula. "That is not something that is cast in stone forever," he said. "As a matter of fact, we are in the process of looking at it."

In a recent interview, Mr. Sohn said banking companies rely heavily on their loan-loss history to determine how much they should sock away, an indicator that is skewed by the stellar credit-quality experience of the past few years. "Obviously times have been good, so it probably tends to understate in some cases the actual credit problems," he said. "It's backward-looking rather than forward-looking."

Hanmi is trying to strike "a better balance between backward and forward," Mr. Sohn said.

Though coverage ratios remain strong at the companies he covers, David Darst, an analyst at First Horizon National's FTN Midwest Securities Corp., said the increase in third-quarter reserves mostly matched the increase in nonperforming assets. Very little actual reserve building occurred, he said.

Susquehanna Bancshares Inc. in Lititz, Pa., may be an exception. The $8.7 billion-asset company, which recently bought Community Banks Inc. in Harrisburg, Pa., announced Nov. 30 that it would take an additional provision of $11.1 million in the fourth quarter, after applying its own methodology for calculating reserves to Community's loan portfolio.

Susquehanna declined to comment, but Mr. Darst said the additional reserve is for $110 million of "special mention" loans that are performing and well collateralized. Because of the collateral, the loans did not previously have a specific allocation, but Susquehanna's methodology requires one.

The additional reserve does not apply to specific nonperforming assets, Mr. Darst said. However, "it implies an expectation for an increase in the migration of loans to nonperforming status."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.