Michael Hughey, chairman of the ABA s accounting committee and a prominent banker, has just that. He objects on the grounds that banks don t have a well-defined formula for determining reserve levels. Banks truly feel that this is an art, not a science, he says. It suggests a level of precision that doesn t exist. But Hughey s objection seems extraordinary at a time when even regulators are convinced that banks can calculate credit risk with enough certainty to set their own capital requirements.
Capital is a reserve kept against things that can t be divined at all, against unexpected losses.
According to Hughey then, banks can calculate unexpected losses well enough to keep capital against them, but when it comes to expected losses, the math isn t up to the job. If the only losses that can be reserved against are incurred not future losses, there seems to be little point in building reserves at all. Banks could simply charge off all worthless loans against earnings on a quarterly basis a prospect that would horrify the industry with its promise of wildly fluctuating earnings. The other alternative is to regard losses as embedded in a portfolio, although the individual loans may still be paying out. Norwood gives the example of a bank that uses data on US unemployment as one indicator driving losses in its consumer loan portfolio.