The way bankers calculate loan-loss reserves, which recently ignited a clash between banking and securities regulators, must become more methodical, the president of the Federal Reserve Bank of New York said.
William J. McDonough, speaking Wednesday night at a dinner attended by about 100 bank analysts, told them that they are in a position to demand that banks take a more disciplined approach to loss provisions. These decisions can be highly subjective.
"I certainly suggest you insist banks have a methodology so when the Securities and Exchange Commission comes in they can say, 'Here's what we have in mind,'" Mr. McDonough said in response to questions at the Bank and Financial Analysts Association's annual banking symposium. "You should insist banks have a rationale."
The issue demands attention, Mr. McDonough said, because potential credit risks are mounting. "The time when bankers make dumb loans is a time like right now, when you're in the ninth year of an economic expansion," he said.
Mr. McDonough's comments appeared to be aimed at defusing tensions that have erupted between banking and securities regulators over whether loan- loss reserve decisions should be more art or science. His remarks came one week after banking and securities regulators said they would jointly craft guidelines on how banks evaluate and document expected losses.
Regulators have generally thought it prudent for banks to save for a rainy day by adding to reserves during periods of robust earnings.
But in a high-profile case last fall involving SunTrust Banks Inc., the SEC voiced concern about the extent to which loss reserves could be used to manage earnings-that is, to manipulate results in a way that masks a bank's true financial condition.
The SEC has been arguing for what analyst Ronald I. Mandle of Sanford C. Bernstein & Co. dubbed a "pay-as-you-go approach" to loss reserves.
Mr. McDonough made clear that he is by no means breaking ranks with banking regulators.
"In our hearts, we think no reserve is too big," he said. Moreover, he emphasized, bankers must be allowed to use their judgment about how much to set aside in reserves: "It has to be institution-specific."
However, Mr. McDonough said, the burden is on banks to show that the method they use to establish loan-loss reserves "demonstrates real judgment, and that there is a paper trail on how you get to the judgment."
"I believe banks can come up with a method that reasonable people will agree is not earnings management," he said.
Observers said many questions remain unanswered in the debate over whether banks are amassing excessive loan-loss reserves.
Banks' loan-loss reserves fall into two categories: specific reserves that should be sufficient to cover any anticipated losses, and general reserves to cover potential but unidentified losses.
"The general reserve is a judgment call, almost by definition," said Raphael Soifer, a bank analyst at Brown Brothers Harriman & Co. "The framework for imposing discipline is in the examination process."
Donna Fisher, director of tax and accounting at the American Bankers Association, said that documenting additions to general reserves would be more difficult than documenting specific reserves.
She added that the banking industry is still not clear on precisely where the SEC's concerns lie.
"It would be a shame to totally revamp accounting for loan losses if we only need to target a piece of it," she said. "It's a big piece of the industry's financial statements, and to change it would be costly and time- consuming."
Lee B. Murphey, chairman of Robert Morris Associates, a Philadelphia- based trade group for credit officers, said he could not argue with a call for improved methods for calculating loss reserves.
"With 9,000 banks in the country, everybody isn't doing it right," said Mr. Murphey, who is also executive vice president and chief credit officer of First Liberty Bank, a $1.6 billion-asset bank in Macon, Ga.
But, he added, "One reason this problem is so complex is that there are still 9,000 institutions in the country, and the risk profile of each one is different. I do not see a one-size-fits-all solution here. There needs to be a high-level policy debate on this issue."