Dukes County Savings Bank in Edgartown, Mass., has expanded its loan portfolio 49% in the last two years, to $182 million as of Oct. 31, largely through significant increases in home equity and business loans.
And as it has diversified into more profitable, but riskier, types of lending, the $300 million-asset Dukes has increased its provision for loan losses - though with resistance from auditors.
"We've been putting a significant amount of money into our loan-loss reserves, and we've been questioned about it frequently," said Chris Wells, Dukes' president and chief executive officer. "It seems like once a week I'm defending it."
This is a familiar battle for bankers and auditors that goes back almost a decade, but many bankers say it has heated up lately.
Bankers say auditors in general are interpreting the Financial Accounting Standards Board regulations that apply to loan-loss reserves - FAS 5 and FAS 114 - more narrowly. As a result, according to bankers, they get less leeway to anticipate future losses, at a time when most are convinced that credit quality is bound to deteriorate.
"The auditors have been cracking down," said F. Weller Meyer, the president and chief executive officer of the $1.3 billion-asset Acacia Federal Savings Bank in Falls Church, Va. "They have been evolving toward a theory that the only reserves financial institutions should have would be those that represent losses that actually exist in loans in the portfolio."
Some observers said auditors might be getting stricter about loan-loss reserves because of a relatively new voice in the lengthy debate, the Public Company Accounting Oversight Board.
Audits are now coming under the scrutiny of the private, nonprofit board, which began full inspections last year. Accounting firms are getting comments about reserves and whether there is documentation to support the amount of money set aside, said Carol Larson, the deputy managing partner of Deloitte & Touche USA LLP's financial services industry group.
Though all banking companies are affected by the accounting standards, community banks, especially thrifts, seem to be struggling more than larger competitors with justifying their reserves.
"Community bankers may not have the internal resources to do some of the modeling that might give them more basis for their estimates," Ms. Larson said. "The big banks are doing more data analysis and more and more quantification of various risks."
Auditors, feeling pressure from the Securities and Exchange Commission's campaign to prevent companies from managing earnings, started keeping closer tabs on loss reserves in the late 1990s. The thinking goes that every dollar put into loan-loss reserves is a dollar less in profits, and that reserving more now to hedge against potential trouble later shortchanges current shareholders, bankers said.
Stellar loan performance over the past few years makes it even more difficult for bankers to justify an increase in loan-loss reserves - another factor contributing to the rising tension with auditors.
For some banks, it is a problem just to defend the reserves they already have. Mr. Meyer said auditors made Acacia move $600,000 from its reserves to its income about three years ago, despite his objections. "We were forced to do it," he said.
Even those who say they have not battled with auditors over loan-loss reserves report that they must document more thoroughly than in the past how they calculated the amount set aside. That is a change for some bankers who relied on simply keeping their reserves within what is considered an accepted range. That is typically about 1% to 1.5% of total loans, though opinions vary about what range is acceptable. Some estimates drift higher than that for commercial banks and lower for thrifts.
Curtis L. Hage, the chairman, president, and chief executive officer of the $987 million-asset HF Financial Corp. in Sioux Falls, S.D., said he discovered how fuzzy the methodology for calculating reserves can be when the thrift company got into business lending about four years ago.
"How would we know if we had the right level of loan-loss allowance for a business that we had no history in? We went about searching to find out how to monitor that," Mr. Hage said. "We found that the industry didn't really have a good method. They just put money in as they could afford it and hoped it was enough."
He said the formula HF Financial devised includes "an environmental factor" that allows for some forecasting of potential future losses. "It's subjective to an extent, but you have to have some trust that people in the business have enough experience to anticipate some of the impact," he said. "A purist would say, 'Well, until it hits your balance sheet, you shouldn't be reserving for it.' I think that's too harsh of a position."
Mr. Hage said he thinks the "comprehensive formula" has helped his company - a thrift with a banklike balance sheet - avoid a clash with auditors.
But he said the loan-loss reserve has been an issue for analysts and investors who think the amount is too low. "Our loan-loss provision is lower than most banks'. That has caused some stress in terms of our stock price."
Frank Schiraldi, an analyst who covers HF Financial for Sandler O'Neill & Partners LP, said that the company had several "credit hiccups" over the past two years, and that the ratio of reserves to total loans had been as low as 50 basis points. But he said the ratio climbed to 74 basis points by the end of the third quarter, lessening the concern lately. "I think it's out of the danger zone in people's minds."
Still, the ratio of reserves to total loans is lower than average, Mr. Schiraldi said. At the end of the third quarter the median for thrifts was 81 basis points, and the median for banks was 115 basis points, according to data from SNL Financial LC in Charlottesville, Va.
That ratio has been decreasing for at least the past three years, as loan portfolios have swollen but banks and thrifts have been reserving less as a proportion of their portfolios.
David Scharf of First Horizon National Corp.'s FTN Midwest Research Securities Corp. said that HF Financial should sock away more money in its reserve. "Theirs is, in my opinion, low."
Thrifts could be running into more resistance than banks in trying to get higher amounts past their auditors, observers say. That's because many thrifts are diversifying into riskier loans, but they tend to have lower provisions to begin with, as well as lower historical losses.
Like HF Financial, Dukes County Savings devised a formula for calculating reserves as it diversified into new types of loans.
Using that calculation, Mr. Wells said, "we determined our loan-loss reserve was underfunded." He said the probable losses work out to $1.6 million, or 0.85% of the loan portfolio.
As a result, Dukes County wanted to add to its reserve, but the auditors balked, because the 51-year-old savings bank's historical losses are much lower, Mr. Wells said. "What is the loss going forward? It's subjective. No matter how you might document it, going forward is the future."
Despite the auditor's objection, in the fiscal year that ended Oct. 31, Dukes County Savings added $275,000 to its loan-loss reserves by putting aside $25,000 a month for 11 of the 12 months, Mr. Wells said. "And the reason we didn't do it for 12 months is our opinions were still separate from what the accountants' were. But then we decided we were going to move on our own with what we felt was the right thing to do."
The infusion raised the total reserve to about $1.3 million, or 0.73% of the loan portfolio.
Mr. Wells said he plans to continue building the reserve this fiscal year. "I'd like to be at 1.5% to 1.75%. But getting me comfortable would be getting to at least between 1% and 1.25%."
Deloitte's Ms. Larson said bankers are complaining enough about overzealous audits that regulators are starting to get interested.
"The one thing that the banking agencies are doing is trying to engage in a dialogue with the PCAOB to understand what their concerns are here and if there's anything the banking agencies can do to help in that situation," Ms. Larson said.
Meantime, to avoid a run-in with auditors, she said, the most important thing for bankers to do is document their considerations. "It's much harder to challenge a judgment when you've laid it out in a careful process."
Analysts seem to be less concerned than bankers about the industry's loan-loss reserves in general.
"I think where reserves are is pretty healthy," Mr. Schiraldi said.
Though the ratio of reserves to total loans is dropping, the ratio of reserves to nonperforming loans has been rising over the past few years - a benefit of unprecedented credit quality. At the end of the third quarter the median reserve for banks was 237% of nonperforming loans, 25 basis points more than two years earlier, and the median for thrifts was 195%, 45 basis points higher.
Banks with less than $1 billion of assets did not gain as much as banks in general. They had a median reserve of 201%, only 5 basis points more than two years earlier.
Sean Jones, a senior vice president in the banking group at Moody's Investors Service Inc., said he expects provision levels to rise across the industry. "We think core earnings are very strong. It's just that less is going to go to the bottom line because of increased provisions."
He said small banks might face relatively faster deterioration in their credit quality, because they generally have greater loan concentrations than large banks, but he is not worried about a crisis. "When I say 'deterioration,' I just mean from current pristine levels."
Besides, he said, small banks tend to have higher core profitability and capital than large banks, giving them more of a cushion against potential losses.
