Defusing a standoff with federal banking regulators, the Securities and Exchange Commission is preparing to scale back its investigation of earnings management at banks.
Government and industry sources said the SEC has agreed to restrict its probings to banks that are obviously violating accounting rules by using loan-loss reserves to smooth out earnings.
The agency's pact with the Federal Reserve Board and Office of the Comptroller of the Currency was reportedly near completion Thursday. None of the agencies involved would comment pending formal release of the agreement, which could come as soon as today.
The agreement, reached in principle Wednesday, follows the SEC's settlement last week with SunTrust Banks Inc. The SEC had refused to certify SunTrust's proxy materials until it agreed to reduce loan-loss reserves by $100 million, or 13%, and restate earnings for the past three years. Without the proxy approval, SunTrust could not close its acquisition of Crestar Financial Corp.
The SEC accused SunTrust of violating accounting rules because it could not link every dollar in its reserves to particular credits expected to go bad, sources said.
The SEC's moves infuriated banking regulators, who argued that banks need flexibility to boost reserves during turbulent economic times, even if they cannot link the set-aside to specific loans, sources said.
Under the expected deal, such excess reserving would be permitted if a bank had historical data on the performance of loan portfolios to support the need for greater reserves.
The agreement came together in principle at a meeting Wednesday that included Treasury Under Secretary John D. Hawke Jr., SEC Chairman Arthur Levitt Jr., and acting Comptroller Julie L. Williams.
Sources cautioned that the exact wording has not been finalized and said at least some of the deal may be implicit, rather than spelled out.
One source described the agreement as a "face-saving" way for the SEC to end its investigation of bank loss reserves-traditionally the purview of bank regulators.
But Diane M. Casey, national director of financial services at Grant Thorton LLP, said the agencies fought to a draw.
"The SEC has gotten its message across that you cannot manage earnings and the banking agencies got their message across that you need to be reserving for loan losses," she said.
Some sources are awaiting proof that the agreement is as advertised.
"The next step will be to see if SEC steps back from existing investigations," said Pamela Martin, director of regulatory relations at Robert Morris Associates, the trade group for loan officers. The SEC has nearly completed investigations of at least two banks and others are still in process, according to sources.
An accounting expert asked whether the new policy would have prevented the SEC from pursuing the SunTrust case. "If SunTrust would still fall into the earnings management category, then there are still going to be concerns," she said.
Earnings management involves building up reserves during boom times, which lowers earnings, and then tapping reserves during an economic downturn, making earnings look better. The result can be a steady trend, regardless of economic conditions.
Last week, Ms. Williams and Fed Gov. Laurence Meyer wrote Mr. Levitt to protest the SEC's moves.
"Bank regulators, both domestically and abroad, presently are questioning the adequacy of loan-loss provisions and reserves in view of deterioration in world markets," Mr. Meyer and Ms. Williams wrote. "It is critical that banking and securities regulators be consistent on this issue."
Cynthia A. Glassman, director of commercial bank risk management at Ernst & Young, agreed the industry is getting conflicting signals.
"Loan-loss reserves are a tool for managing risk by using the good times to prepare for the bad times," she said. "It seems odd to have the SEC upset during a period when we are going from the good times to the bad times."