You don’t often see Washington regulators publicly raising alarms about banks’ accounting practices. That’s why a speech this week by the comptroller of the currency, Thomas Curry, deserves more attention.
The way Curry described the situation, you get the sense that some banks’ numbers may be too good to be true. He made clear he wasn’t warning about an imminent crisis. Yet he cautioned that some banks seemed to have been “scrimping on their allowances against their loan losses,” which is a fancy way of saying they may be fudging their numbers.
To understand better what he was referring to, here’s a brief accounting primer. Loan-loss allowances are the reserves that lenders set up on their balance sheets for perceived bad loans. Provisions are the expenses they record to boost those allowances. As losses are confirmed, lenders charge off the uncollectible amounts, reducing the allowances.
Sometimes lenders decide, in hindsight, that their allowances are too big. When this happens, they may undo some of the provisions they had previously booked. Bankers refer to this as “releasing reserves,” which boosts earnings and capital. This has been happening at several large U.S. banks lately, such as JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo & Co. Investors often refer to these gains as “low-quality earnings.”
Curry, who became comptroller in April 2012, said some reserve releases are to be expected as underwriting standards, loan performance and the economic climate improve. “But for some banks, the ease with which the allowance could be repurposed as earnings has proved habit-forming,” he said, without naming any companies. He noted that “this is happening despite loosening credit underwriting standards, which suggests that risks are increasing that may result in larger charge-offs.”
Loan-loss provisions and charge-offs have both been on the decline industrywide for a few years. Curry pointed out, though, that provisions have been falling at a faster rate -- a signal that banks’ optimism about their loan quality might be outpacing reality. During the second quarter of this year, lenders regulated by his office recorded about $6.1 billion of provisions, equivalent to only 56.6 percent of their net charge-offs, according to data compiled by the agency. A year earlier, provisions were $10.4 billion, equivalent to 67.1 percent of net charge-offs.
One result is that recent surges in capital, which banks tout as a sign of resilience, may in part be illusory. An easy way for a bank to overstate its capital is to underestimate its losses. To find a period when banks’ provisions exceeded net charge-offs you would have to go back to the fourth quarter of 2009.
One good sign is that the banking industry’s loan-loss allowances are still more robust than they were during the years leading up to the financial crisis. Allowances at comptroller-regulated banks were equivalent to about 2.1 percent of total loans and leases, as of June 30. That percentage has been declining the past few years, after topping 4 percent in 2010. Back in early 2007, the figure was a mere 1.1 percent, which helped make banks look healthier and more profitable than they really were.
If banks are low-balling their provisions, accounting standards may be partly to blame. The way the rules stand now, lenders typically must meet two conditions before they can recognize loan losses. It must be “probable” that a loss has been incurred as of the balance-sheet date. The loss also must be reasonably estimable. Otherwise, no loss gets recorded.
These sorts of judgments and estimates can get extremely complex, especially for banks with millions of customers. The answers may be difficult for outsiders to challenge. Bankers who want to show lower losses can put on blinders, at least for a while, as many did during the financial crisis. Likewise, it may be tempting for some banks to overestimate losses and create excess reserves that they can dip into later like a cookie jar when they want to show higher earnings and capital.
Curry said he favors a proposal by the U.S. Financial Accounting Standards Board that would change the rules so that banks could recognize credit losses more quickly. Instead of having to decide whether it’s probable that a loss has been incurred, they could record “expected” losses. On paper, this should make it harder for banks to delay losses, because the threshold for recognizing them would be lower. (That is, if the banks do what the rules say.)
This has a possible downside, too. If Curry is worried about excessive reserve releases now, just wait to see what happens when banks get to book loan losses earlier and more often. Banks that were inclined to create cookie-jar reserves before could wind up having an easier time doing so.
Perhaps the best we can hope for is that the solution won’t be worse than the problem. To his credit, Curry is flagging the issue. Banking regulators didn’t emerge from the last crisis looking so good. This counts as progress.
(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)
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