Banks, and credit unions, too, are loudly objecting to the Financial Accounting Standards Board's attempts to increase loan loss reserves. They have "slammed the FASB," in The Wall Street Journal's phrasing, for proposing this conservative idea.
What a mistake the banks are making. They ought instead to welcome the opportunity to get their loan loss reserves up to truly prudent levels, in line with the classic wisdom of the banking business — if not exactly in the fashion FASB suggests, then in some fashion.
A fundamental problem of our banking system is that cycle by cycle, it has come to rely far too much on the government. As the FDIC sticker proclaims in the lobby of every bank, the bank is "backed by the full faith and credit of the United States government." It ought to be the goal of self-respecting banks not to need this government support, and to stand on their own. Preparing for inevitable future credit crises through bigger loan loss reserves would be a good step in the right direction.
But when can you build the required loan loss reserves? You can afford to only in the good times, of course — like now, when the banking industry has just earned $41 billion in the last quarter. That is exactly when you may think you don't need them. But the good times are also when credit mistakes are being made — the mistakes that will be so painful in the future bad times. As the old and true banking maxim tells us, "Bad loans are made in good times." And the bad loans other people make in the good times will weaken your loans, too.
When the bad times do come, in every cycle, they are usually worse than people had predicted they would be. They are always worse than your worst-case scenario was. Recall the real estate lending bust of the 1970s; the simultaneous sovereign debt, oil bubble and farmland bubble collapses of the 1980s, with four commercial banks a week failing, let alone the thrifts; the commercial real estate bust of the 1990s, and later in the decade, multiple international debt crises; and the vast losses from the simultaneous bubbles in housing and commercial real estate in the 2000s. And a potential bust is currently in process, with another cratering of a leveraged oil price boom combined with the elevated risk of a hard landing in emerging markets.
Banking is an inherently risky business, needless to say. Since loss reserves were too small in all the bad times of the 1970s, 1980s, 1990s and 2000s, it necessarily follows that actual profits in the preceding good times were not as big as they were purported to be. Optimistic credit booms produce illusory banking profits, along with illusory asset prices. Banking profits can only be understood over a credit cycle: The optimists who don't build reserves are more likely to end up in the clutches of the government when the bust comes.
Classic banking prudence was forcefully stated by an old-fashioned real banker, George Champion, who was chairman of the then-top bank, Chase Manhattan, in the 1960s. Reflecting in 1978 on the essentials of banking, Champion gave us this memorable advice: "I have long said that what they ought to do is to increase the reserve for bad debts until they get to a point of having at least 5% of total loans. This would not be out of line in view of the enormous losses that had to be written off in the last few years."
He was describing the credit losses of the 1970s, but the same can be said of the credit losses of the 1980s, 1990s and 2000s.
Describing an increasingly distant past era when banking was more prudent, Champion continued: "We tried to put out the most conservative statement possible. We did everything we could to set up reserves wherever possible in terms of questionable loans. We knew we would come into periods when we needed to call on reserves and the statutory limitation on reserves was so bad that there was no way to set up as much as we felt it was necessary to have, prudent to have." How right he was.
Champion advised institutions to contribute one-quarter of 1% of loans each year to the reserves for bad debt until reserves reached 5%, and to avoid getting into a position where an institution had to rely on a government bailout.
My advice is to take Champion's advice. Seize the opportunity offered by FASB to get loan-loss reserves up. If your profits go down in the good times, that's just recognizing the reality of the bad ones.
Alex J. Pollock is a distinguished senior fellow at the R Street Institute in Washington. He was president and CEO of the Federal Home Loan Bank of Chicago 1991 to 2004.