WASHINGTON - Federal bank regulators on Friday hammered an accounting trade group's proposal to severely restrict banks' loan-loss reserves, claiming it would mask institutions' true financial condition.

In a letter to the American Institute of Certified Public Accountants, the regulators requested a meeting to discuss the proposal and said the draft "will result in information that is misleading to users of financial statements, including both investors and regulators, and therefore will not improve financial reporting."

Among other things, the proposal would bar banks from holding any unallocated reserves and require that every addition to reserve accounts be accompanied by documentation of a specific loss. While the task force's aim is to reduce excessive reserves, the regulators wrote, "In practice, the guidance is likely to produce loan-loss allowances that are understated, particularly as the condition of borrowers weakens in periods preceding an economic turndown."

Office of Thrift Supervision Director Ellen Seidman said the regulators' response was tinged by frustration with what they see as an unexpected departure from guidance on the same subject that the banking agencies and the Securities and Exchange Commission issued in a joint letter last summer.

"We are disappointed that in the face of the ongoing discussions among the banking agencies and the SEC, the task force has put forward a draft proposal that appears to conflict with the July 12 guidance - particularly in the area of unallocated loan-loss allowances - and could have the impact of leading institutions to hold inadequate loan-loss reserves," Ms. Seidman said in an interview Friday.

Industry reaction was similarly negative. "From what I see, it looks as though this is not good economics and is not good public policy," said Allen W. Sanborn, president and chief executive officer of the Risk Management Association, formerly Robert Morris Associates. "It looks to have been developed in a vacuum, without input from the practitioners."

The regulators' letter responds to a draft proposal by an AICPA task force assigned to clarify how generally accepted accounting principles apply to banks' loan-loss reserves. The task force, headed by Martin F. Baumann, a partner in PricewaterhouseCoopers' insurance practice, is scheduled to present the draft to the group's Accounting Standards Executive Committee on July 26. A final draft surfaced Friday. (It is available at americanbanker.com.)

If accepted by the committee, the draft would then be forwarded to the Financial Accounting Standards Board. If approved by FASB, it would be released for a 90-day public comment period, after which a final position would be adopted.

The task force was formed in March 1999 during a long-running battle between banking regulators and the SEC. The commission has accused banks of holding excessive reserves in order to "manage" their earnings, and forced SunTrust Banks Inc. to lower reserves by $100 million and restate three years' of earnings. The bank regulators claimed reserves should be maintained at or above their current levels to preserve safety and soundness.

A draft of the proposal obtained by American Banker shows the AICPA task force is leaning toward the SEC's position, in which bank reserves are based less on management's judgment of what is adequate than on objective evidence of losses.

The June 12 letter, obtained Friday, is signed by officials of the Federal Reserve Board, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corp. It urges the task force to tone down the rhetoric, warning, "Loss recognition may be delayed if institutions believe the task force's guidance requires greater certainty of a loss event than is prudent."

The bank regulators told the task force to "reconsider" allowing banks to reserve only for loans that have been downgraded by the institution or have gone into default. Such indicators, they wrote, "should not be the sole determinants of loss recognition on loans." Banks, they said, should be allowed to continue basing loan-loss reserves on such things as historical experience and economic factors.

Finally, regulators raised the possibility that the AICPA position differs in direction from the FASB's own stated goal of moving toward fair-value accounting for financial instruments. By contrast, they added, current and emerging practice in the banking industry "is within the framework of FASB's goals."

Donna Fisher, director of tax and accounting at the American Bankers Association, predicted that the bank regulators' letter will have an impact. "This is a very strong letter," she said. "I think it will be very hard for the AICPA to ignore it."

In fact, Elizabeth Fender, AICPA's director of accounting standards, said Friday that the regulators input is welcome.

"This is part of the process and we plan to meet with them," she said. "Their concerns are valid but it is so early that I hate to get into too much of a debate about the technical aspects of the proposal."

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