"Stress Tests" and bank reserves --- a look back
As we await what will likely be an anticlimatic disclosure from Treasury on the stress test scenario, we see headlines like "Banks may struggle to raise money after stress tests..." which appeared on www.bloomberg.com this morning. This alarmist tone about credit losses called to mind another culprit in the current plight --- a change to accounting treatment of bank reserving policies in the mid-1990's.
Following the early 1990's recession and under pressure from an over zealous OCC and an SEC that was extremist on mark to market accounting, the FASB changed the accounting rules for bank reserves, or the allowance for loan losses. Up until that time banks traditionally were able to use some discretion, with the oversight of their accountants and regulators, to determine how much of their earnings to set aside to protect prudently against future loan losses. Squirrels know enough to store up nuts, bears know when to fatten up, and believe it or not even bankers know that credit cycles are just that, cycles, and that putting away some money in good times is the right thing to do. The OCC, SEC, and FASB decided that doing so was managing earnings and not reflecting true performance, so the rules were changed to allow reserving for loan losses based only on current non-performing assets and on formulaic percentages of assets in the weakest categories of performance. This meant that in good times reserves were set aside that were appropriate for the good times and that in bad times there were no longer adequate reserves to cover losses that any veteran banker knew would eventually come around.
Of course the old system could be abused and used to manage earnings, and it was done precisely by some banks who could always tell the analysts what they would earn in any given quarter to the penny. That was a failure in oversight, however, and not a failure of the rules. Regulators and accounting firms covered their incompetence in the early '90's in a way that scapegoated the banks and destroyed a basic principle of reserving for credit losses.
It's unlikely that the old ways would have prevented the mortgage debacle, forever a sleazy business that is highly cyclical and one that attracted the worst kind of business people from the 1960's onward, but for credit card, small business, and corporate loans there were clear historical models that suggested that reserves be bolstered even when times are good. While equity investors may have been deprived of some tradeable volatility by banks using these models, fixed income investors could be heartened by a better economic model than exists under current rules that were put in place in the early '90s.
"Stress Tests" today might have highlighted levels of expected credit challenges that had already been anticipated at some level in an accounting sense. Boring stuff maybe, but it's right.
Following the early 1990's recession and under pressure from an over zealous OCC and an SEC that was extremist on mark to market accounting, the FASB changed the accounting rules for bank reserves, or the allowance for loan losses. Up until that time banks traditionally were able to use some discretion, with the oversight of their accountants and regulators, to determine how much of their earnings to set aside to protect prudently against future loan losses. Squirrels know enough to store up nuts, bears know when to fatten up, and believe it or not even bankers know that credit cycles are just that, cycles, and that putting away some money in good times is the right thing to do. The OCC, SEC, and FASB decided that doing so was managing earnings and not reflecting true performance, so the rules were changed to allow reserving for loan losses based only on current non-performing assets and on formulaic percentages of assets in the weakest categories of performance. This meant that in good times reserves were set aside that were appropriate for the good times and that in bad times there were no longer adequate reserves to cover losses that any veteran banker knew would eventually come around.
Of course the old system could be abused and used to manage earnings, and it was done precisely by some banks who could always tell the analysts what they would earn in any given quarter to the penny. That was a failure in oversight, however, and not a failure of the rules. Regulators and accounting firms covered their incompetence in the early '90's in a way that scapegoated the banks and destroyed a basic principle of reserving for credit losses.
It's unlikely that the old ways would have prevented the mortgage debacle, forever a sleazy business that is highly cyclical and one that attracted the worst kind of business people from the 1960's onward, but for credit card, small business, and corporate loans there were clear historical models that suggested that reserves be bolstered even when times are good. While equity investors may have been deprived of some tradeable volatility by banks using these models, fixed income investors could be heartened by a better economic model than exists under current rules that were put in place in the early '90s.
"Stress Tests" today might have highlighted levels of expected credit challenges that had already been anticipated at some level in an accounting sense. Boring stuff maybe, but it's right.
posted by John Borden at 10:18 AM
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