FASB Eyes Stricter Loan-Loss Standard

In a rule-making step that could erode banks' capital, the Financial Accounting Standards Board is discussing a more painful standard for establishing loan-loss reserves.

At issue is how banks calculate loan losses that determine reserve levels and how probable loan losses must be before reserves are required.

If new standards are adopted, virtually every bank could be forced to add to loan-loss reserves. That would result in lower earnings and reduced capital.

"Theoretically, it affects everybody if [the Board] comes out with a standard of probability and how you have to set your loan-loss reserves," said a money-center banker involved in accounting policymaking.

Bankers Fear Repercussions

That has bankers concerned. "We probably disagree with the direction they're currently going in," said David Morris, chairman of the American Bankers Association's Accounting Committee and director of accounting policy at Chase Manhattan Bank. But he cautioned that "it's a little hard to know where they're going to come out on this."

Thrifts already operate under detailed rules covering how they handle loans unlikely to be repaid in a timely fashion. Treatment of these impaired loans requires an estimate of future cash flows from the assets discounted to reflect present value.

If the resulting sum is less than the assets' book value, then the thrift must set up loan-loss reserves to satisfy the difference.

In contrast, banks have more flexibility.

Current Rule Lacks Detail

Though current standards call on banks to record losses on loans, there are no details on how losses should be calculated, according to Thomas Taylor, chairman of the banking committee of the American Institute of Certified Public Accountants and a partner at Ernst & Young.

Now the Standards Board is considering whether to tighten the rules. A draft of a proposed rule change could start making the rounds of the nation's banks sometime in the next several months, sources said.

Meanwhile, the Standards Board is weighing a change in guidelines on when banks must take reserves. Current standards are vague. They call for banks to set aside reserves when it appears probable they will not receive the principal and interest payments set in the original terms of the loan.

Definition of |Probable'

But government officials have complained that banks are interpreting "probable" too loosely. In an April report on 39 failed banks, the General Accounting Office charged that banks and their auditors are not stepping up and reserving against what look like problem loans until it is almost a given that total payments will fall short of the expected amount.

"The requirement that a loss be |probable' before it is reserved has, in the case of banks, come to mean |virtually certain' rather than |more likely than not,'" the report said.

Accordingly, the Standards Board may eventually tighten the definition of probable. In late July, the Board decided merely to reemphasize that reserves should be taken when losses are probable, according to Danita Ostling, a project manager at the Board. But with related issues in flux, discussion on this matter could resume, sources said.

"It will certainly have an effect on any restructured loan," said Zane Blackburn, chief accountant at the Office of the Comptroller of the Currency.

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