At first glance, it would seem hard to make the case that bank accounting rules should be viewed as something to keep us awake at night. The remake of The Exorcist, perhaps, but not bank accounting.
Yet the American Institute of Certified Public Accountants has proposed a rule that should scare all of us. If adopted, this proposal could genuinely unhinge the safety bumpers from our financial services system. It would make banking organizations much more subject to volatility, if not outright failure, when the next recession hits, as it inevitably will.
Unwilling to let sleeping dragons lie, the AICPA is proposing to revise the accounting rules governing the credit reserves that banks appropriately accrue for anticipated rainy days. Bank regulators have for some time pressed banks to keep these reserves at strong, reasonable levels. Reserves provide a store of value that is used to offset credit losses when they occur.
Even when a bank is fundamentally sound over the long term, short-term earnings pressure, plus heavy credit losses, can put on such a squeeze that the institution fails. Strong reserves let a bank offset its losses during a down period, which helps keep it from failing.
As if we needed a wake-up call, the banking crisis of the early 1990s when hundreds of banks failed and the economy was gripped by a credit crunch underscored the need for banks to hold reserves. I lived through this period as both a bank regulator and counselor to banks, and it was no fun.
The AICPA draft proposal would let a bank keep a reserve only when it could demonstrate, in accordance with an acceptable methodology, that this reserve reflected a loss the bank deemed probable in respect to a specific credit.
The rule tells us not to put money away even for anticipated rainy days unless we can allocate every penny to a specific event that we think probably will occur. This approach is wrong. Losses often cannot be so accurately predicted for individual loans, though loss estimates are possible for groups of loans. The AICPA draft proposal would interfere with the use of such estimates in calculating the proper reserves.
Moreover, the draft rule would force banks to move in the direction of much more uniform and rigid rules for reserving methodology. I view this as troubling, too. Though great strides have been made in modeling credit risk, the fact is that credit risk is so complex and temporal that it currently takes, and I think will take for some time, considerable experience and judgment to manage correctly.
Managing credit risk, including setting the proper reserves, is not amenable to a one-size-fits-all, inflexible model; it is not a spectator sport. Rather, to manage this risk and keep our institutions safe, credit professionals need the flexibility to use their best judgment and to react to changes in our dynamic global marketplace. With the AICPAs proposal, common sense goes out the window.
This new rule is needed, AICPA tells us, to prevent banks from using reserves as a slush fund to manage earnings. In my own experience as a bank regulator, banker, and counselor to banks, I have not encountered earnings management as a significant problem. If it occurs, the Securities and Exchange Commission and other government regulators can discipline the institutions involved. And on occasion such disciplinary action has been taken.
Even if there remains some modest problem regarding managed earnings, which I sincerely doubt, the proposed AICPA rule throws out the babies (and the rest of us) with the bath water. It is, indeed, cause to sleep a little less soundly tonight.
Mr. Ludwig, comptroller of the currency from 1993 to 1998, is managing partner of Promontory Financial Group LLC in Washington.