WASHINGTON — Comptroller of the Currency John Dugan reignited the debate over loan-loss provisions Monday by arguing that the current crisis proves regulators were right to demand more unallocated reserves during the housing boom.
Though he never mentioned the Securities and Exchange Commission directly, Dugan's speech nevertheless appeared directed squarely at the agency, as well as bankers and their auditors. The SEC argued for years that bankers should justify and document reserves, claiming that unallocated provisions gave executives too much room to manipulate earnings.
But Dugan said that stance helped exacerbate the financial crisis.
"We would be considerably better off today if there had not been so many impediments to building larger reserves," he told a conference hosted by the Institute of International Bankers. "Had banks built stronger reserves during the boom years, they would not need to reserve as much now; they wouldn't need as much additional capital now; and they would be in a stronger position to support economic growth."
Dugan acknowledged criticism of unallocated reserves, including the fear that they could be used to make earnings look less volatile.
But the comptroller questioned whether the "incurred loss" reserve model works. Under existing rules, bankers must document their reasoning for a loan-loss provision, often using historical loss rates. Regulators have encouraged bankers to be more subjective in their analysis, in case recent historical loss rates proved overly optimistic, but the SEC has insisted provisioning remain as objective as possible.
The debate traces back to 1998, when the SEC objected to reserve levels at SunTrust Banks Inc. and required the company to restate earnings. Since then bankers and their auditors have been much more conservative in using their own judgment when calculating reserves.
"It's high time to ask and answer some hard questions about loan-loss provisioning," Dugan said. "Does the current interpretation and implementation of the incurred loss model result in the adequate use of forward-looking judgmental factors to permit appropriate early-in-the-cycle loss provisioning? Or does the model itself, by its very nature, prevent that result by allowing loss recognition only when a loss has somehow been incurred?"
The incurred loss model is too procyclical, he said, forcing bankers to raise provisions only after losses have already started to materialize and "magnifying the impact of the downturn."
In the fourth quarter the industry set aside $69.3 billion, or more than twice what they did a year earlier, to cover bad loans. Provisions made up over half — 50.2% — of net operating revenue. That figure has not been so high since the second quarter of 1987, when it was 53.2%.
Dugan said he was addressing the issue as part of a working group of the Financial Stability Forum, which also includes an SEC commissioner, and he argued that changes are clearly needed.
"We need to do a better job of telling banks and their auditors, both in the United States and elsewhere, about the degree to which banks are permitted to use nonhistorical, forward-looking judgmental factors to justify provisions to the loan-loss reserve," he said. "We also need to clarify that the documentation requirements for doing so are not a case of 'mission impossible.' "
The potential misuse of reserves can be addressed by increasing disclosure of bank reserve methodology and practices, Dugan said.
"If banks believe they need more flexibility to use their expert judgment to recognize losses in the credit cycle, then that judgment should be able to withstand the glare of investor scrutiny as an important check on the process," he said. "Pillar 3 of Basel II would appear to be an appropriate forum for developing a consensus on this subject that would have a broad and consistent impact on bank financial reporting around the world."
Dugan also said regulators and others should give more credit for a high level of loan-loss provisions. He noted that under Basel II capital rules, reserves are only counted as 1.25% of Tier 2 capital.
"That's too stingy," he said. "Given their primary, capital-like loss-absorbing function, loan-loss reserves should get greater recognition in regulatory capital rules — a result that would help remove disincentives for banks to hold higher levels of reserves."
Dugan was not the only regulator calling for changes Monday to Basel II. In a speech to the same group, Federal Deposit Insurance Corp. Chairman Sheila Bair argued that the crisis exposed flaws in the accord's advanced approach used to calculate a large bank's risk-based capital.
She cited a report Moody's Investors Service Inc. released in December that found bankers using the advanced approach reported a reduction in risk-weighted assets.
"If the advanced approach says banks need less capital at the height of a global banking crisis, imagine the financial leverage it would encourage during good times," Bair said. "With the dangers of excessive leverage so clearly demonstrated over the last 18 months … it would be imprudent to determine regulatory capital based solely on the advanced approach."
She reiterated a call for a global leverage ratio.
"I strongly believe that global leverage capital requirements are sorely needed," she said. "And they should apply for all systemically important financial firms, regardless of charter."