The issue of loan-loss reserves could place bankers in the middle of a simmering dispute between regulators and accountants.

Several bank regulators have made it clear in the last month that they don’t want banks releasing reserves too quickly. The promise of added scrutiny has prompted some banks to change the methodology for reserves, either by adjusting the impact of historical losses or increasing scrutiny of projections.

But bankers can only adjust the numbers so much before their accountants start to question how a new methodology might influence the bottom line.

“If a bank is over-reserved that’s a problem,” says David Seleski, the president and chief executive at Stonegate Bank in Fort Lauderdale, Fla.

Certified public accountants refuse to sign off on audits if a reserve fails to accurately reflect financial performance, Seleski says. “At some point, the banks will be in the middle, with the regulators on one side and the CPAs are on the other side.”

Accountants and regulators have squared off before over reserve methodology, with a notable twist. A decade ago, SunTrust Banks was chided for reserving too much. Criticism about excessive reserves went away during the financial crisis. Improved credit quality has brought reserve methodology back to the forefront, but the concern now is that bankers may be too eager to reduce reserves.

Last month, representatives for the Federal Reserve Board and the Office of the Comptroller of the Currency cautioned bankers about releasing reserves too quickly. A concern is that banks could pull the trigger too early in an effort to boost earnings.

“We are watching reserves very closely, and we expect national banks and federal savings associations to maintain them at appropriate levels,” Comptroller of the Currency Thomas Curry said during an Oct. 29 speech at a Risk Management Association conference. “We are ready to take action if and when it is needed.”

The Fed is also watching allowances for loan losses, even in situations where a bank is in a position to ratchet back provisions, Kevin Bertsch, the associate director of the Fed’s division of banking supervision and regulation, said during an Oct. 15 panel on regulatory hot buttons. The panel was part of the American Bankers Association’s annual conference in San Diego.

To regulators’ credit, they remain cautious about future credit quality, particularly on loans that involve real estate, in a fragile economy.

Regulators “will tell you credit quality is not as bad as it was but they haven’t seen things improved dramatically,” says Bill Massey, an accountant and consultant at Saltmarsh, Cleaveland & Gund. “There are still inherent risks.”

Reserves at banks with less than $20 billion in assets have changed very little in the past year. The average loan-loss reserve was 1.89% of gross loans at Sept. 30, down 3 basis points from March 31 and just 1 basis point from a year earlier, according to data from SNL Financial compiled by FBR Capital Markets.
Banks have historically maintained a reserve equal to 1% to 1.5% of gross loans, Seleski says. “That was the other extreme end of the spectrum,” he says. “There wasn’t a whole lot of thought that went into it at all.”

Bankers once looked at the past two years of loan losses to calculate reserves. Now they are looking back three years or more.

“We try to build a method that we can consistently use in the good times and bad times,” says Barry Harvey, the chief credit officer at Trustmark (TRMK) in Jackson, Miss. “We feel that three years represents a reasonable cycle.”

Since 2010, credit quality has improved, allowing Trustmark to shrink its allowance, Harvey says. Still, the $10 billion-asset company’s provision increased in the third quarter by 26% from a quarter earlier, to $3.4 million, because of concerns about one big loan.

Regulation on calculating reserves lacks a specified time frame for considering historical losses.
“There’s no written rule or guidance as to what loss period needs to be reflective of the risk in the portfolio,” says Michael Lundberg, the national director of financial institution services at McGladrey. “Normally, every bank has the . . . responsibility of looking at their portfolio and deciding” the right time length.

While it’s hard to adjust historical numbers, bankers can adjust other factors they consider as they look to appease regulators as the fiscal cliff and global economic uncertainty loom.
“We’ve been looking more at the crisis in Europe and the ripple effect that could still happen,” Seleski says. “There are a lot of aspects to it, but there’s no question that you want to keep the regulators happy.”

If banks comply with regulatory reservation, it will likely keep reserves from falling, leaving a lingering drag on earnings. Shrinking assets would increase allowance ratios, but many banks have already tapped that option.

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