Depository Institutions: Divergent Loan Loss Methods Undermine Usefulness of Financial Reports
Released: 1994-10-31T00:00:00

Letter

Introduction

In the late 1980s, loan loss reserves established by depository institutions were criticized by regulators as being inadequate to cover losses from bad loans. From 1980 to 1992, approximately 2,700 federally insured depository institutions failed, at a substantial cost to the insurance funds and taxpayers. Bad loans for agriculture, energy, less developed countries, and commercial real estate contributed to the large number of failures. In 1992, the condition and performance of the nation’s depository institutions improved substantially. Commercial banks posted record earnings of $32 billion while savings institutions posted aggregate earnings of $6.7 billion, continuing a positive trend that began in 1991. For 1993, this improvement continued with commercial bank profits of $43.4 billion and savings institution profits of $7 billion. Recently, some depository institutions have been criticized by regulators for maintaining more reserves than they need.

Background

The management of a depository institution establishes loan loss reserves through periodic provisions or charges to operating expenses. When a provision for loan losses is recorded by management, loan loss reserves increase by a like amount. Loan loss reserves adjust the institution’s loans receivable to reflect amounts that management estimates will not be recovered. When losses associated with loans or portions of loans are confirmed or determined to be certain, the loans or portions of loans are removed from the books of the institution by writing off the loan against the loan loss reserve. This results in removing amounts from the reserve that are associated with the confirmed losses.

Loan loss provisions and reserves are key indicators of loan quality that are included in the financial reports of depository institutions. Depositors, investors, and other financial report users rely on these indicators to make decisions about the financial condition of the institution. Regulators evaluate the adequacy of loan loss reserves during on-site, full scope, safety and soundness examinations. These examinations are conducted periodically to identify problems early and control risk. Regulators also monitor reserves through financial reports received between examinations to track institutions’ financial condition and performance. Because of their importance to various users of financial reports, loan loss provisions and reserves need to accurately reflect specifically identified loss exposures as well as other inherent loss exposures in the institution’s loan portfolio.

Authoritative accounting rules for financial reporting are primarily established by the Financial Accounting Standards Board (FASB). These accounting rules are referred to as generally accepted accounting principles (GAAP) and are promulgated through the issuance of statements of financial accounting standards (SFAS) by FASB. The American Institute of Certified Public Accountants (AICPA), through its Accounting Standards Executive Committee (AcSEC), issues accounting guidance on issues not otherwise covered in authoritative literature. The Securities and Exchange Commission (SEC) has statutory authority to set accounting principles, but as a matter of policy it generally relies on FASB and the AICPA to provide leadership in establishing and improving accounting principles. However, SEC frequently issues accounting and disclosure regulations to supplement guidance provided by FASB and the AICPA.

We have previously reported the existence of significant problems in measuring and accounting for losses from problem loans and regulatory examinations of loan loss reserves. In our study of 39 banks which failed without warning in 1988 and 1989, we found that asset valuations the Federal Deposit Insurance Corporation prepared after the banks failed increased their loss reserves from $2.1 billion to $9.4 billion. Although we acknowledged that several factors contributed to this difference, such as deterioration in loan values subsequent to failure, we concluded that a significant portion of it was caused by institutions making inadequate estimates of loan losses prior to failure.

In our assessment of regulatory examinations, we found that the four federal financial institution regulators—the Office of the Comptroller of the Currency (OCC), the Federal Reserve Board (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS)—did not have a uniform risk-based methodology to judge an institution’s loan loss reserves. Examiners lacked a consistent framework to quantify loan portfolio risks such as real estate exposure, unfavorable economic conditions, and deficient loan policies. Methods for assessing loan loss reserves varied among the regulators and the lack of a generally accepted method made it difficult for the regulators to successfully challenge management’s estimates when the examiners believed reserves were inadequate.

Objectives, Scope, and Methodology

Our objectives were to determine whether loan loss reserve methodologies used by insured depository institutions resulted in reserve amounts that were justified by supporting analysis and comparable among institutions and accounting standards provided by FASB and regulatory guidance provided by OCC, FRB, FDIC, and OTS were sufficient to promote fair and consistent financial reporting of loan loss reserves among depository institutions.

To determine whether loan loss reserve methodologies used by insured depository institutions resulted in reserve amounts that were justified by supporting analysis and comparable among institutions, we conducted case studies of 12 depository institutions, each with total assets over $1 billion, which we judgmentally selected. They are referred to as Institutions A through L in this report. To include a cross section of depository institutions, we selected institutions supervised by OCC, FRB, FDIC, and OTS that were currently being examined or had been examined during the last 12 months. For geographic diversity, we selected institutions located in California, Maryland, New York, North Carolina, Texas, and Virginia.

For each institution, we reviewed all major components of the loan loss reserve methodology, including individual loan assessments, analysis of historical experience, and other means used for reserve allocations. In addition, we reviewed the institution’s overall loan loss assessment, including the criteria and methods used to estimate losses for both commercial and consumer loans. To accomplish our work, we reviewed examination working papers for loan loss reserves and the institution’s loan loss reserve documents, when they were available. We also conducted detailed interviews with the regulatory examiner-in-charge and/or management to discuss the institutions’ loan loss reserving methodologies and the application of accounting rules and regulatory guidance.

To determine whether accounting standards and regulatory guidance were sufficient to promote fair and consistent financial reporting, we reviewed all relevant accounting and regulatory guidance for establishing loan loss reserves. This included SFAS No. 5, Accounting for Contingencies; SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings; SFAS No. 114, Accounting by Creditors for Impairment of a Loan; AICPA audit and accounting guides for banks and savings institutions; OCC Banking Circular 201, Allowance for Loan and Lease Losses; FDIC May 1991 Policy Memorandum for Allowance for Loan and Lease Losses; examination manuals for each of the four federal regulators; and the Securities and Exchange Commission’s Financial Reporting Release No. 28, Accounting for Loan Losses by Registrants Engaged in Lending Activities.

Each of the four federal depository institution regulators and FASB provided written comments on a draft of this report. These comments are presented and evaluated in chapter 2 and are reprinted in appendixes I through V. Our work was performed between November 1992 and March 1994 in accordance with generally accepted government auditing standards.

Loan Loss Reserves Were Incomparable and Included Large Unjustified Amounts

The 12 depository institutions we reviewed used markedly different methods to establish their loan loss reserves, which resulted in incomparable reserves, and, in most cases, significant portions of their reserves were not justified by supporting analyses. Most of the institutions based large amounts of their reserves on loss history. Historical loss rates provide a valuable basis for estimating future losses and can be appropriately used to establish reserves for nonproblem loans and smaller-balance pools of loans. However, the methods used by the institutions to determine and apply historical loss experience did not consistently identify and measure loan loss exposure, which resulted in incomparable reserve amounts. In addition, historical loss rates were routinely applied to establish reserves for individual problem loans even though individual loan assessments provide the most accurate means to identify and measure loss exposure for such loans. Finally, most of the institutions maintained large supplemental reserves which were not linked to quantitative analyses of loss exposure or other evidence that demonstrated that the amounts were needed to cover likely loan losses.

Neither accounting standards nor regulatory guidance provided sufficiently detailed direction about how loan loss reserves should be established to ensure that reserves are clearly justified and comparable among institutions. Given such flexibility, the institutions used widely diverse loan loss estimating methods that resulted in incommensurable reserves and also reserves that may not have reflected the true risk of loss in their loan portfolios.

Loan loss reserves that cannot be compared or that misrepresent risks in loan portfolios impede investors, creditors, depositors, regulators, and other users of financial reports from understanding the true financial condition of depository institutions. Such reserving practices also impede early warning of changes in an institution’s financial condition and timely regulatory actions to protect the banking and savings and loan insurance funds.

Reliability and Comparability Are Key Elements of Useful Financial Reporting

The primary purpose of financial reporting is to provide information to report users which they can utilize in making investment, credit, and similar decisions. Statement of Financial Accounting Concepts (SFAC) No. 2, Qualitative Characteristics of Accounting Information (FASB, May 1980), discusses criteria that are necessary for accounting information to be useful for making business and economic decisions. Reliability and comparability are two of the major criteria discussed in the statement.

SFAC No. 2 states that accounting information is reliable to the extent that users can depend on it to reflect the economic conditions or events that it purports to represent. Reliability of accounting information stems from representational faithfulness and verifiability. In other words, to be reliable, accounting information must be verifiable and directly related to the economic resources and obligations of the enterprise, as well as to transactions or events that change those resources or obligations. With regard to comparability, SFAC No. 2 states that information concerning an enterprise gains greatly in usefulness if it can be compared with similar information about other enterprises and with similar information for different periods of time or points in time for the same enterprise. The significance of information, especially quantitative information, depends to a great degree on the user’s ability to relate it to some benchmark. One of the principal reasons for accounting standards is the desire for such benchmarks for purposes of making financial comparisons.

Loan Loss Reserves Are a Key Factor in Determining the Financial Condition of Depository Institutions

Loans are the largest single component of most depository institutions’ assets; therefore, loan loss reserves and related provisions are critical to understanding the financial condition of a depository institution, including identification of changes in its credit risks and exposures. Provisions directly affect an institution’s current earnings and represent the amount necessary to adjust the loan loss reserve to reflect estimated uncollectible loan balances outstanding. In theory, as the risks and exposures from uncollectible amounts in the loan portfolio increase or decrease, this should be reflected by a corresponding increase or decrease in the provision and reserve. Because of their importance as indicators of financial condition, loan loss provisions and reserves must reliably reflect estimated losses in the loan portfolios of institutions and be subject to meaningful comparison.

The loan loss reserve must be sufficient to cover both specifically identified loss exposures as well as other inherent loss exposures in the institution’s portfolio. Therefore, an adequate reserve hinges on (1) timely identification and analysis of loss exposures on impaired loans, and (2) analysis of loss exposures on unimpaired loans considering past trends and current conditions. Loss exposures on larger balance impaired loans are generally best evaluated using individual loan assessments, which include detailed review of the financial condition of the borrower, loan payment history, fair value of collateral, loan guarantees, and other relevant information. In contrast, loss exposures on unimpaired loans and smaller-balance loans are generally best evaluated on a group basis by assessing historical loss experience for pools of loans with similar characteristics, adjusted for changes in economic and business conditions which affect the institution’s lending operations.

Results of Individual Assessments Often Not Used

All 12 institutions regularly reviewed their commercial loans individually as part of assigning risk ratings or grades for credit quality to these loans. However, to establish reserves for commercial loans that were identified as problem loans through this process, most of them routinely reverted to loss history in lieu of using individual loan assessment results or to supplement the results. We were not able to determine the percentage of the institutions’ total reserves that were established using these approaches because the amounts could not be sufficiently segregated from other reserves based on historical losses, including reserves for pools of nonproblem loans. However, based on our review of the institutions’ policies, discussions with management or examiners, and review of samples of problem commercial loans, we found that historical losses were reverted to in lieu of or in addition to individual problem loan assessments in the following cases.

Institutions D and E used average historical loss rates that closely resembled loss rates for the overall banking industry in place of individual loan assessments. Institution D always used these rates to set reserves for problem commercial loans. Institution E used the loss rates only when they resulted in more reserves than the individual assessments. Institutions A, B, and H used their own historical loss rates to establish reserves for individually assessed loans when the rates resulted in more reserves than the individual assessments. Institution G used its own historical losses to establish reserves for individually assessed loans when no loss exposure was identified by the individual assessments. Institutions C, F, I, and K used detailed assessments to establish specific reserves for individual loans. These institutions used their own loss history to establish additional reserves over and above reserves determined from the detailed assessments. In at least one case, these additional amounts were intended to cover possible deterioration in the current fair value of the loan’s collateral.

Because individual loan assessments provide the most accurate means to identify and measure loss exposure for larger-balance impaired loans, the use of historical losses by the institutions in place of or in addition to individual assessments may have overstated or understated reserves for these loans and thus misrepresented the risk in their loan portfolios.

For example, the collateral gap for one problem commercial real estate loan we reviewed at Institution D was $21.2 million. Because there was no evidence in the loan examination file we reviewed that other payment sources, such as loan guarantors, could be relied upon to cover this gap, we determined that the loss exposure for the loan was the full $21.2 million. However, as shown in table 2.1, the reserve that was established by Institution D with loss rates that closely resembled industry averages was only $8.1 million. We believe that this $13.1 million difference represented a material understatement of Institution D’s loss exposure.

Also, as shown in table 2.1, had this same loan been in the portfolio of Institution E, reserves would have likely covered most if not all of the $21.2 million deficiency. This is because Institution E’s policy was to reserve for the greater of estimated losses based on loss rates which closely resembled industry averages or individual loan assessments.

Institution F, under its policy, would have likely established reserves for the entire $21.2 million deficiency noted above plus an additional $2.4 million, based on its own loss history, to cover possible deterioration in collateral value.

The use of historical industry loss rates, or even historical loss rates for the institution, in place of individual loan assessments can just as easily materially overstate loss exposure on an individual problem loan where the collateral value or other payment source sufficiently covers the outstanding loan balance. For example, another commercial real estate loan we reviewed at Institution D had an outstanding balance of $21.5 million, and the appraised fair market value of the loan’s collateral was $25 million. Notwithstanding the fact that the collateral adequately covered the loan balance, the institution reserved $4.3 million for this loan as a result of using loss rates which closely resembled industry loss rates.

Historical losses based on industry averages or an institution’s own past experience do not accurately reflect the specific borrower’s current financial condition, ability to make timely loan payments in the future, the current fair value of loan collateral, or other payment sources. As a result, the historical loss factor cannot identify potential loss in a specifically identified impaired loan as reliably as a detailed assessment. The use of historical loss rates in place of individual loan assessment results or to supplement such results can produce unreliable reserves and misrepresent the level of losses present in individually assessed loans.

Inconsistent Methods Used to Calculate Historical Loss Rates

Historical loss analysis can provide useful indications about how large groups of homogenous loans have performed in the past. This type of analysis can be used as a basis to estimate inherent losses on nonproblem commercial loans, as long as the estimate is appropriately adjusted in a verifiable manner to reflect current characteristics of the loan portfolio.

Such analysis is also effective for estimating inherent losses in smaller, low-risk loans such as consumer loans.

All of the institutions used historical losses to establish reserves for loans that were not individually assessed. As previously discussed, most of the 12 institutions also used historical losses in some form to establish reserves for specifically identified problem loans even when individual loan assessments were performed. Thus, significant amounts of the reserves of most of the institutions were based on historical losses. However, because the methods used to determine and apply these historical losses varied widely the resultant reserve amounts were not comparable among the institutions.

As shown in figure 2.1, the 12 institutions used loss history to establish from about 11 percent to 87 percent of their total loan loss reserves. Nine of the institutions relied on loss history to determine 40 percent or more of their total reserves.

As shown in table 2.2, the major methods that were used by the institutions to determine historical loss rates ranged from a relatively simple approach which used actual losses for 1 year to a relatively complex method known as migration analysis. Migration analysis is a process by which loans are tracked and recorded by the institution as they move through various risk grades until they are charged-off as losses. Using migration analysis, an institution can estimate losses for the current year and subsequent years for loans in each loan grade.

As noted in table 2.2, Institutions B, C, I, and J used migration analysis to derive historical loss factors for their commercial loan portfolios. Most of the other institutions used either actual charge-offs over a relatively short time period or average annual charge-offs to compute historical loss rates. Generally, institutions that use annual charge-offs to develop historical loss rates attempt to identify losses that are likely to be confirmed and charged-off over the coming year. In contrast, institutions can use methods such as migration analysis to attempt to capture losses that will likely be confirmed and charged-off during the life of the loan portfolio. Because commercial loans can have maturities beyond 1 year, the loss rates developed using methods such as migration analysis will generally cover a longer period and, therefore, will be greater than rates based solely on annual charge-offs.

The institutions also used markedly different time periods of past experience to determine historical loss rates. As shown in table 2.2, the institutions’ historical bases ranged from 1 year to 10 years for commercial loans and from 3 months to 6 years for consumer loans. The objective of using longer time periods to determine historical loss rates is to preclude a particularly good or bad year from having an inordinate effect on the institution’s current reserves. Ideally, a sufficient number of years should be used so that historical loan performance can be gauged over the course of the institution’s economic cycle. However, the objective of using shorter time periods such as 1 year is typically to reflect only an institution’s most recent loss experience. Reserves based on several years’ losses can be significantly different than reserves based on the most recent 12 months, which could be a particularly good or bad year.

For example, for one institution we reviewed, the average charge-off rate was 1 percent of total loans from 1989 through 1992. Had the reserves been based on this average, they would have amounted to about 13 percent of the institution’s capital at the end of 1992. However, had the reserves been based on charge-offs for the most recent 12 months, which amounted to 2.6 percent of total loans during 1992, the institution would have established reserves of about 33 percent of 1992 capital. Clearly, in this case, the use of the average charge-off rate would have resulted in significantly different loss estimates than use of the most recent charge-off rate.

Finally, most of the institutions used their own loss history to develop historical loss rates. However, as mentioned previously, Institutions D and E used rates that closely resembled industry averages to establish reserves. The industry averages were developed by the institutions’ federal regulator, with no adjustment for differences in loan policies, loan administration practices, portfolio composition, or economic conditions affecting individual institutions.

Loss reserve methods that rely predominantly on standard industry loss percentages are likely to create misleading loan loss provisions and reserves because they do not consider the particular characteristics of the institution’s loan portfolio. In addition, the use of such percentages creates reserves that are not comparable to reserves of institutions which use their own loss experience to estimate losses.

For example, Institution H’s loan loss reserve for commercial loans, which was based largely on its own loss history, totaled approximately $708 million. However, application of the loss rates used by Institution D to Institution H’s commercial loan portfolio balances, would have increased its reserve for commercial loans to about $1,139 million, or by 61 percent.

These inconsistencies in the application of historical loss experience to determine current reserve estimates resulted in wide disparities in reserves among institutions. These disparities were exacerbated by the fact, as stated previously, that most of the institutions used historical loss experience as their primary means to estimate loan loss reserves. The resultant incomparability in reserves can be a major impediment to financial report users, as it hampers their ability to assess the true financial condition and relative health of depository institutions.

Large Supplemental Reserves Not Adequately Justified

Supplemental reserves are reserves established by management over and above amounts determined by analyses of individual loans and loss history. Although supplemental reserves may be needed to cover specific loss exposure not identified by individual loan assessments and loss history, they can conceal the true condition of an institution’s loan portfolio and distort its earnings and capital position if used inappropriately. Further, unjustified supplemental reserves are not comparable to reserves that reflect only estimates of likely losses.

As shown in figure 2.2, supplemental reserves comprised over 30 percent of the total loan loss reserves for 7 of the 12 institutions we reviewed.

In most cases, the supplemental reserves were not quantitatively linked to an analysis of loan loss exposure nor was there adequate support to demonstrate that they were based on reasonable estimates of likely losses. The rationale for supplemental reserves varied among institutions. We were told by management or examiners that the supplemental reserves were intended to adjust loss history for current conditions, provide a cushion for future uncertainties, or appease regulators. Regulatory examiners for two institutions told us that the supplemental reserves resulted, in part, from management not reducing reserve amounts recorded in the institutions’ records to reflect the most recent estimates of loss exposure. By categorizing the differences between current loss exposure estimates and their recorded reserves as supplemental reserves, these institutions avoided taking a negative loan loss provision.

Although two institutions linked a portion of their supplemental reserves to specific portfolio risk analyses, the majority of supplemental reserves were not adequately linked to specific loss exposure. Explanations provided by management or examiners for supplemental reserves generally did not demonstrate that the reserves were justifiable loan loss estimates. Several examples of substantial supplemental reserves that were not adequately linked to loan portfolio risk and likely losses follow.

Institution B built its supplemental reserve to about 40 percent of its total loan loss reserve after federal regulators directed it to increase its reserve after an examination in 1992. In the third quarter of 1992, the institution’s detailed analysis of loan losses indicated that it needed an additional $301 million in loss reserves. However, the regulator required the institution to take a loss provision of $400 million and increase its loan loss reserve by a like amount. According to a senior management official, although not justified by the institution’s loan portfolio analysis, management agreed to take the additional $99 million provision to comply with the regulator’s decision. Even though the institution’s detailed analysis of its loan portfolio in the 3 subsequent quarters indicated that it had sufficient loan loss reserves, it continued to charge earnings by taking additional provisions each period with the encouragement of the federal regulator. At the end of the second quarter of 1993, the institution’s reserve was about $612 million over what was justified by its own loan portfolio analysis. This amounted to about 15 percent of capital and exceeded the previous year’s earnings by over 80 percent. Institution L’s supplemental reserve comprised about 48 percent of its total loan loss reserve. Documents prepared by the institution indicated that most of this reserve was considered to be excess. The federal regulatory examiner for the institution told us that he believed the institution used the excess reserve as a plug or cushion for the difference between the reserve that was needed to cover estimated losses and the reserve recorded in its books. Although the federal regulator did not criticize the level of the institution’s reserve, the state regulator believed that it was too high. According to the federal regulatory examiner, the institution was not directed to adjust its reserve but requested to adequately support all supplemental reserve components in the future. Institution H’s supplemental reserve comprised about 44 percent of its total loan loss reserve. This amounted to about 8 percent of its capital and 56 percent of its earnings. Neither the institution nor the federal regulator demonstrated that the supplemental reserve was based on reasonable estimates of likely losses. According to management officials, most of the supplemental reserve was established through management judgment and consensus and was intended to cover possible losses associated with anticipated bulk sales of some of the institution’s bad loans, potential errors in loan grading, inexperience with acquired banks, and local and national economic conditions. However, there was no linkage of these factors to reserve amounts in the analyses we reviewed. Further, factors used to set supplemental reserves for specific types of loans were not supported. One official stated that the institution maintains a large supplemental reserve, in part, to “keep the regulators happy.” He stated that regulatory examiners have relied on “rule of thumb” percentages to determine reserve adequacy and have been more comfortable when the institution maintains a large reserve. Institution E had a supplemental reserve that comprised about 32 percent of its total loan loss reserve. Management officials chose to keep the supplemental reserve at current high levels to protect the institution against credit concentrations and possible economic swings even though they had noted that each of the institution’s loan quality indicators had improved. Management officials stated that the large supplemental reserve was added to the current loan loss estimate, in part, to make the estimate equal to the reserve recorded in the institution’s records. This enabled the institution to avoid adjusting the recorded reserve downward to reflect the current estimate of loss exposure. The supplemental reserve amounted to about 73 percent of earnings and 6 percent of capital.

Supplemental Reserves May Conceal Changes in Portfolio Condition

Large supplemental reserves can mask changes in an institution’s loan portfolio that are critical to understanding its financial condition. Previously established supplemental reserves can be used to absorb current increases in estimated losses. In such instances, an institution can avoid increasing its current loan loss provision and reserve to reflect the deterioration in the portfolio. In these cases, neither the institution’s current loss provision nor changes in existing reserves would be reliable indicators of the increased risk in its loan portfolio. Large supplemental reserves can also overstate risk by inappropriately hiding improvements in an institution’s loan portfolio.

Table 2.3 illustrates hypothetically how supplemental reserves can conceal current loan portfolio deterioration as well as improvement.

As shown in table 2.3, by taking loan loss provisions during years when the recorded reserve is greater than estimated loss exposure, the institution can build a substantial unjustified supplemental reserve. The build-up of the supplemental reserve not only masks the improvement in the condition of the loan portfolio during years 1 through 3, but also enables the institution to conceal the significant increase in loss exposure which occurs during years 4 and 5. Loss exposure increases by 60 percent between years 3 and 5; however, the loan loss reserve increases by only about 9 percent. As a result of the unjustified supplemental reserve, neither the institution’s annual provisions nor changes in its recorded loan loss reserve balances reflect the significant changes which occur in the quality of its loan portfolio.

In order for institutions’ loan loss reserves and related provisions to provide reliable information about the quality of their loan portfolios, these loan quality indicators must coincide with the institutions’ verifiable estimates of loss exposure. The use of large unjustified reserves undermines the credibility of these important financial condition barometers. As previously noted, 7 of the 12 institutions we reviewed had supplemental reserves which totaled at least 30 percent of their total reserves. Conceivably, these institutions could use these reserves to absorb increases in estimated loan losses and not record loss provisions or adjust reserve levels to reflect changes in the condition of their portfolios for several periods. Conversely, if their loan portfolios were improving and they continued to build supplemental reserves by maintaining the same levels of provisions and reserves as in prior periods, these loan quality indicators would not reflect this improvement.

Some amount of supplemental reserve may be needed to cover specific loss exposure over and above that identified by analysis of individual loans and loss history. However, an unjustified supplemental reserve can be used to manipulate earnings and capital position and, therefore, distort financial reports such that investors, creditors, depositors, regulators, and other report users do not have a clear basis for making decisions about the financial condition of an institution. This lack of transparency is compounded when financial statement users attempt to compare institutions whose reserves are not comparable because they use significantly different approaches to establish reserves. As a result, institutions that use unjustified supplemental reserves can seriously compromise both the reliability and comparability of financial information: two key elements of useful financial reporting.

Authoritative Guidance Does Not Provide Adequate Standards for Establishment of Reserves

Accounting and regulatory guidance for the establishment of loan loss reserves is too flexible to ensure reserves are determined in a consistent and reliable manner. Only broad authoritative accounting standards exist for establishment of overall loss reserves, and they have been applied liberally in practice. Regulatory guidance discusses the types of risks that need to be considered in setting reserves; however, the guidance does not provide sufficient information about how risks should be quantified and linked to reserve allocations. Further, guidance provided by the four federal regulators is not always consistent. The lack of adequate standards has resulted in reserve amounts which cannot be meaningfully compared among institutions and which may not represent the true level of risk in institutions’ loan portfolios.

The primary authoritative accounting literature governing establishment of overall loss reserves is SFAS No. 5, Accounting for Contingencies. Although SFAS No. 5 states that provisions for losses should be made only when losses are probable and can be reasonably estimated, neither it nor any other authoritative accounting literature provides guidance or establishes parameters to ensure that loan loss history and other factors that are used to identify losses meet these two conditions.

Recently, FASB issued SFAS No. 114, Accounting by Creditors for Impairment of a Loan. SFAS No. 114 provides loss recognition and measurement criteria for individual loans that are identified for evaluation of collectibility. The statement specifies that, for loans which are individually assessed, impairment should be measured on the basis of the present value of the loan’s expected cash flows, the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. SFAS No. 114, however, does not specify how a creditor should identify loans that are to be individually assessed for collectibility, address how an institution should determine loss reserves for loans that are not individually assessed, or provide additional guidance for the establishment of overall reserves. Therefore, while SFAS No. 114 provides specific guidance for determining when a loan has been impaired and how to quantify the impairment, it does not resolve the problems we identified in our review.

Further, while the guidance in SFAS No. 114, if properly implemented, may be an improvement over current practice for assessing individual impaired loans, it will still lead to inconsistencies in establishing reserves, particularly for collateral dependent loans. The three alternative approaches under the statement could result in very different loss estimates for the same loan because the fair value of the loan collateral could be quite different from the current market price of the loan. The current market price, in turn, is also likely to be different from estimated discounted cash flows to be received from the borrower. In addition, the timing of cash receipts may be difficult to predict. In commenting on the Exposure Draft for SFAS No. 114, we advised FASB of our view that fair value accounting should be required for all collateralized problem loans, which would eliminate this inconsistency. We believe that the fair value of collateral is the most objective and accurate measure to use to determine the loss exposure on a collateral dependent impaired loan.

Regulatory guidelines developed by the four federal regulators are not consistent and generally lack specific direction for the establishment of overall loan loss reserves. The guidelines for three of the regulators state that loan loss reserves must be adequate to absorb all estimated losses that meet SFAS No. 5’s two conditions for loss recognition; however, one regulator’s guidelines do not mention these criteria. Regarding the use of loss history, none of the regulatory guidelines explain the merits and limitations of using migration analysis over other approaches to identify and measure losses that are probable and estimable. Further, while the guidelines for two of the regulators do not address the number of years that should be included in determining historical losses, one regulator recommends 5 years and another requires 3 years.

Regarding the way loss history should be applied to set reserves for loans, one regulator’s guidelines clearly state that loans individually assessed should not receive reserve allocations based on loss history. However, the guidelines for another regulator require institutions to add reserves to those determined from individual loan assessments. A policy official for the regulator told us that institutions are required to add reserves for the fully collateralized portion of individually assessed problem loans. Two regulators do not specifically address the application of historical information to individually assessed loans in their guidelines.

Some of the requirements and suggested procedures in the regulators’ guidelines promote the establishment of reserves over and above losses that are clearly probable and based on reasonable loss estimates. Although each of the regulator’s guidelines list a number of valid factors that an institution should consider in setting reserves, no discussion is included in any of the guidelines about how such factors should be assessed to ensure that all amounts allocated to the loan loss reserve are for likely losses and supported by verifiable analysis. Further, one regulator’s guidelines encourage institutions to use supplemental reserves to cover errors in the loss estimating process but do not provide parameters for establishment of such reserves.

Management officials of three institutions told us that better guidance is needed for loan loss reserves. Officials of the first institution stated that accounting and regulatory guidance is not helpful to institutions in setting reserves because they do not address how various subjective factors should be measured. They also stated that there is too much variation in how reserves are established by institutions and that such variation needs to be addressed by accounting and regulatory guidance so that loss reserves are comparable among institutions. Officials of the second institution stated that regulators and management are frustrated because there is no consistent approach to establishing loan loss reserves. They stated that one regulator goes beyond GAAP by requiring the institution to set reserves for fully secured portions of loans. A management official of the third institution stated that the guidance needs to include standards for the use of loss history so that institutions use a common basis for establishing loan loss reserves.

The lack of accounting and regulatory standards for establishment of overall loan loss reserves has led to the evolution of a hodgepodge of accounting practices with no clear and common objectives. Without adequate accounting and regulatory standards, management of depository institutions are afforded excessive flexibility in establishing loan loss reserves, and regulators may be prone toward arbitrary determinations of required reserve levels.

Federal Regulators Issue Interagency Policy Statement for Loan Loss Reserves

On December 21, 1993, OCC, FRB, FDIC, and OTS issued an interagency policy statement for loan loss reserves. The statement supplements existing regulatory guidance and is intended to provide consistent approaches among the regulators to assess reserve adequacy. The statement clearly states that an institution’s reserves must be maintained at a level to absorb estimated losses that meet the loss criteria of GAAP. Therefore, each of the regulators acknowledge that provisions and reserves must be adequate to cover losses that can be reasonably estimated and that will likely occur as stated in SFAS No. 5. The interagency statement, however, does not adequately address the problems we identified in our review—reserves not being comparable and possibly misrepresenting portfolio risk because of the use of loss history to supplement individual loan assessment results, inconsistent use of loan loss history, and unjustified supplemental reserves.

According to the statement, the institution should rely primarily on an analysis of the various components of its portfolio to determine reserves, including analysis of all significant credits on an individual basis. For individual loans, however, it does not prohibit or discourage institutions from using loss history to supplement reserves determined from specific detailed assessments. Further, it does not state whether institutions should reserve for portions of individual loans that are adequately covered by collateral. As previously discussed, institutions’ use of loss history in place of individual loan assessment results can significantly overstate or understate loss exposure for problem loans and produce reserves that are not comparable.

Although the interagency statement states that losses should be estimated over the remaining effective lives of loans classified substandard and doubtful, it does not provide specific guidance or minimum requirements for the use of migration analysis or other techniques to ensure that losses are estimated in this manner. Rather, the statement states that methods for determining historical losses can range from a simple average over a relevant number of years to more complex techniques, such as migration analysis. No discussion is included regarding what constitutes a relevant period of years for computing loss averages for loans or what must be done to ensure that all institutions consistently measure losses for the lives of their current loan portfolios. As previously discussed, numerous inconsistencies in the determination of historical loss experience created disparities in reserves among institutions.

Finally, according to the interagency statement, management’s analysis of loan loss reserves should be conservative and include an “additional margin” so that overall reserves reflect the imprecision inherent in most estimates. In addition, the statement lists numerous factors that management should consider that are likely to cause current estimated losses to differ from historical loss experience. As previously discussed, most of the institutions’ reserves were comprised of significantly large supplemental reserves which were not adequately justified. This resulted in reserves which were not subject to meaningful comparison and which may have distorted the true condition of the institutions’ loan portfolios.

We believe the statement will encourage institutions to continue to use large unjustified supplemental reserves because it does not emphasize that inherent imprecision in loss estimates can result in overstatements as well as understatements of actual losses. As a result, institutions will be encouraged to add to their estimates to cover potential error even if the estimates are too high. Further, no discussion is included in the guidance to ensure that allocations to reserves are linked to the specified factors in a reasonable and verifiable manner and that the factors are used only to identify and measure likely losses.

Conclusions

Current loan loss reserve practices used by the 12 depository institutions we reviewed often did not result in meaningful assessments of the risk of loss due to uncollectible loan balances. In addition, the flexibility in accounting for loan loss reserves resulted in incomparability of reserves among the depository institutions and gave them the opportunity to use reserves to manipulate their operating results and capital. While establishment of reserves will always require some degree of management judgment, it should not be an exercise in total management discretion, nor should it be subject to arbitrary regulatory adjustments. However, until more specific standards are established by authoritative accounting bodies, incomparable and potentially unreliable reserves will continue to hamper the usefulness of financial reports of depository institutions.

Recommendations

We recommend that FASB, in close consultation with OCC, FRB, FDIC, and OTS, develop a comprehensive standard for establishment of loan loss reserves, which includes a requirement that reserves for all large impaired loans be based on detailed individual assessments, and no specific reserve amounts in excess of those determined from such assessments should be allowed for those loans. For collateral dependent commercial loans, a reserve should be established to cover the difference between the outstanding loan balance and the estimated recoverable amount from the collateral based on an assessment of the collateral’s fair value; guidance regarding the use of historical analyses to estimate inherent losses existing in the portion of the portfolio which has not been specifically analyzed for impairment. Such guidance should address methods of analyses as well as the appropriate time periods of historical data to be included; and a requirement that all portions of the reserve, including any supplemental amounts, should be directly linked to and justified by a comprehensive documented analysis of current loss exposure in the loan portfolio and that the periodic provision for loan losses adjust the reserve balance to the level determined necessary by such an analysis.

Comments and Our Evaluation

Each of the four federal depository institution regulators and FASB commented on the report. The regulators generally shared our concerns about the need to adequately identify and measure loan losses. However, FDIC, FRB, and OTS indicated that, from a regulatory perspective, it was beneficial for institutions to maintain supplemental reserves and, in some cases, add-on reserves for individually assessed impaired loans. In addition, they expressed their view that recently issued regulatory and accounting guidance discussed in the report are generally sufficient to address our concerns. OCC generally supported our recommendation that FASB address deficiencies in GAAP for the determination of loan loss reserves, but stated it believes that the existing body of regulatory guidance provides an appropriate framework for banks to determine an adequate level of reserves and examiners to evaluate the sufficiency of those reserves.

FASB disagreed with our conclusion that the lack of accounting and regulatory standards for establishment of loan loss reserves has led to the evolution of a hodgepodge of accounting practices with no clear and common objectives. It stated that it believes that SFAS No. 5 establishes a broad set of clear and common objectives which can be applied to recognizing loan losses. It also stated that if creditors ignore those objectives, “hodgepodge” accounting certainly could be the result. However, FASB’s response differed significantly from the responses of some of the regulators with regard to the objectives of establishing loan loss reserves. Further, although the regulators’ responses were often similar, we noted key differences in how they characterized various aspects of their interagency and other regulatory guidance.

We believe that these differences between FASB and the regulators, and among the regulators themselves, reflect the potential for inconsistent interpretations of current accounting and regulatory standards and underscore the need for more definitive, comprehensive authoritative accounting guidance for the establishment of loan loss reserves. In addition, we believe the general support of FDIC, FRB, and OTS for reserving approaches that include supplemental and add-on reserves is further symptomatic of uncertainty over how to best identify and measure probable existing loan losses. We further believe that reserve shortfalls as well as excesses are likely to result from this uncertainty, since fluctuations in loan quality are not being effectively reflected by the reserving methodologies currently used by institutions and examiners.

The draft of this report sent out for comment also included a recommendation to the regulators to implement the principles of our recommendations to FASB if FASB did not act to adopt those recommendations. After consideration of the differences in responses to the report among the regulators, including the differences in interpretations of existing joint regulatory guidance, we decided to delete the recommendation to the regulators in the final report. However, we encourage the regulators to support FASB in its efforts to develop a comprehensive accounting standard for establishment of loan loss reserves.

The following sections include summaries of the comments we received from FASB and the regulatory agencies on our conclusions and recommendations and our evaluation of those comments. The written comments we received from FASB, FDIC, FRB, OCC, and OTS are reprinted in appendixes I through V, respectively. Our comments on additional issues raised by the four regulators and FASB are also included in these appendixes. It should be noted that, in the case of FASB, although our draft report was circulated to all Board members, its written comments do not represent FASB’s official position. The Board takes formal positions on accounting matters only after appropriate due process. In that regard, FASB stated its Financial Accounting Standards Advisory Council would include the issues discussed in the report as a potential project in its 1994 survey questionnaire.

Comments on Individual Loan Assessments

FASB and OCC generally agreed with our first recommendation that reserves for all large impaired loans should be based specifically on detailed individual loan assessments. However, they also stated that review of loans with similar risk characteristics on an aggregated basis is acceptable. FDIC and OTS agreed that significant impaired loans should be individually assessed and stated that such assessments are recommended by existing regulatory guidance. However, OTS also believed additional reserves over and above those based on individual assessments should be provided in some cases. FRB stated that basing reserves on individual loan assessments of large impaired loans was required under existing regulatory guidance and is standard banking practice, but also advocated consideration of standard industry loss percentages in establishing reserves for individual problem loans.

In responding to our first recommendation, FASB indicated that SFAS No. 114, which applies to all large loans that are impaired, requires that impairment of those loans be measured on a loan-by-loan basis, unless the loans have common risk characteristics. In that case, FASB stated SFAS No. 114 allows the use of aggregation techniques to measure impairment of loans with common risk characteristics. FASB also indicated that if a creditor measures and recognizes impairment for a particular loan in accordance with SFAS No. 114 and SFAS No. 5, any additional loss recognition for that loan would not be appropriate. Therefore, FASB stated it expects that many of the issues raised about individual measurement in the report will be resolved, or at least mitigated, when financial institutions adopt SFAS No. 114.

OCC made similar comments with regard to aggregation techniques in responding to the first recommendation. OCC generally agreed that banks should analyze all significant doubtful credits individually and attempt to estimate probable loss associated with each loan. However, it stated that as a practical matter, loan-by-loan estimates are not always possible, even for loans that are classified doubtful and especially for loans that are classified substandard. Therefore, OCC believes that an estimate based on the bank’s own historical loss experience on a pool of similar loans (adjusted for changes in conditions and trends) is an acceptable, and often more realistic, alternative.

We agree that the type of aggregation techniques described by FASB and OCC can provide meaningful estimates of losses on impaired loans with similar risk characteristics. However, the individual impaired loans we reviewed which were held by the institutions in our sample were large commercial real estate loans. These loans generally have different types of collateral, borrower characteristics, loan terms, and geographic locations. The loans we reviewed had all been assessed individually by the institutions and by the examiners for purposes of loan classifications, and in most cases sufficient information was available to estimate probable losses. Nonetheless, many institutions reverted to establishing reserves based on loss history in lieu of or in addition to using the results of these individual assessments for large impaired loans. The report includes examples of how these practices can distort the loss exposure in individual loans and resulted in reserves that could not be meaningfully compared among institutions.

SFAS No. 114 does not specifically preclude institutions from using loss history factors to add on to reserves established based on individual loan assessments. In addition, SFAS No. 114 does not specify how a creditor should identify loans to be evaluated for collectibility. We believe this provides institutions with the flexibility to structure identification criteria such that certain impaired loans would be excluded, thereby allowing continued use of historical factors and other methods to set reserves for large impaired loans. Therefore, we do not agree with FASB that SFAS No. 114 resolves or mitigates the issues relative to individual loan assessments raised in the report.

In its comments on our first recommendation, FDIC stated that the 1993 Interagency Policy Statement, its own guidance, and SFAS No. 114 already require institutions to assess all significant credits on an individual basis. FDIC also stated that the Federal Financial Institutions Examination Council’s (FFIEC) Request for Comment on Implementation Issues Arising From New Loan Impairment Accounting Rule, which was issued on May 13, 1994, states that the federal regulators do not plan to automatically require reserves over and above those established using SFAS No. 114 criteria.

OTS made similar comments in response to our first recommendation, but also specifically stated it disagreed with the portion of the recommendation that indicates that no specific reserve amounts over and above those based on detailed individual assessments of large impaired loans should be allowed. OTS stated that there may be losses inherent in any pool of assets, including pools of loans that have been individually assessed. It went on to say that certain individually assessed loans still pose sufficient risk to an institution to warrant an additional reserve. As a result, OTS believes it is appropriate to use both individual loan assessments and broader assessment techniques which incorporate risk factors that are not loan specific to establish reserves for large impaired loans.

As discussed in the report, the 1993 Interagency Policy Statement referred to by FDIC and OTS does state that an institution should rely primarily on an analysis of the various components of its portfolio to establish reserves, including an analysis of all significant credits on an individual basis. The statement also clearly states that an institution’s reserves must be maintained at a level to absorb estimated losses that meet the loss criteria of GAAP. However, as discussed in the report, the statement does not prohibit or discourage institutions from using loss history to supplement reserves determined from specific detailed assessments.

Additionally, while FFIEC’s May 13, 1994, Request for Comment does state that the federal regulators do not plan to automatically require reserves over and above those established using SFAS No. 114 criteria, it also states that an additional allowance on impaired loans may be necessary based on consideration of institution-specific factors, such as historical loss experience. The implication of this statement appears to be that under certain circumstances it is appropriate for institutions to establish reserves for large impaired loans over and above what is determined necessary from detailed individual loan assessments. OTS’s comments indicate that it takes this viewpoint. We believe this flexibility and inconsistency in regulatory policy will continue to promote inconsistent and, at times, inappropriate, reserving practices for large impaired loans.

FRB stated that the approach we advocate with regard to large impaired loans has been general banking practice for many years and is consistent with SFAS No. 114. FRB further stated that estimating the collectibility of large impaired loans on an individual basis is inherently judgmental and any single institution has limited historical experience with which to assess fully the many factors that affect the collectibility of an individual credit. Thus, institutions and examiners should also consider the loss experiences of other lenders on similar problem loans.

Our findings do not support FRB’s contention that the use of individual loan assessments to set reserves for large impaired loans has been general banking practice for many years. As stated in the report, most of the institutions in our sample reverted to loss history in lieu of using individual loan assessment results to establish reserves for problem commercial loans. In addition, the two banks in our sample that were regulated by FRB used average historical loss factors which appeared to be based on industry averages as the basis to establish their reserves, including those for large impaired loans. Individual loan assessments were performed on these loans, but were often used only to determine the loan classifications. Standard percentages were then applied based on these classifications to establish the reserves. As stated in the report, standard industry loss percentages do not consider the particular characteristics of the institution’s loan portfolio. We demonstrated in the report how the use of such industry averages can both understate and overstate reserves on large impaired loans. In its comments, OCC agreed with our position on this issue.

Comments on Use of Historical Analyses

Regarding our second recommendation that guidance is needed for the use of historical analyses to estimate inherent losses existing in the portfolio, FDIC, FRB, and OTS all believed that the interagency policy statement provided adequate guidance on the use of historical loss experience. However, their specific interpretation of that guidance varied, especially with regard to how industry averages for loss experience should be used. OCC did not refer to the interagency policy statement, but indicated it believes that a bank’s use of historical analyses should be based on its own experience, and not on industry averages. FASB stated it believes that providing specific guidance in this area would impede the banks’ ability to use the historical data that are most relevant to their particular situation.

FDIC and FRB indicated that regulatory guidance provided in the interagency policy statement is generally sufficient with regard to the use of historical analyses to estimate loan losses. They stated that the policy statement purposely does not provide specific, detailed guidance on the length of past experience that should be used by an institution or the methods that institutions should use to factor historical losses into their reserve estimates. They believe differences among institutions in estimation methods are warranted based on differences in institution-specific factors and due to consideration of the benefits versus the costs of utilizing more complex, data-intensive approaches such as migration analysis.

We recognize that institutions vary greatly in size and complexity and have different financial and technical resources. Therefore, we believe it is important for standards and guidance to focus on alternative historical loss methods, including the time periods used to develop ratios or other historical data, so that probable losses that exist in similar loan portfolios of different institutions are identified and measured in a manner that produces comparable results. While the approaches used to accomplish this may be somewhat different, the basic parameters used should be the same, and therefore the results should be comparable.

FRB also stated that while specific guidance to institutions on past loss experience is not provided in the policy statement, the statement does provide quantitative guidance based on industry loss experience that examiners should use to review the overall reasonableness of an institution’s reserve estimates. OTS made reference to this same guidance in the policy statement; however, it characterized it as specific guidance for the use of historical loss experience, including appropriate time periods. It stated that the guidance provides that experience based on the institution’s average annual rate of net charge-offs over the last 2 or 3 years for similar loans, adjusted for current conditions and trends, should be used. It also stated that industry-average net charge-off experience is appropriate only when the institution does not have a sufficient basis for determining this amount.

The specific guidance in the interagency policy statement that OTS and FRB referred to is listed under the “Examiner Responsibilities” section of the statement as follows. “After analyzing an institution’s policies, practices, and historical credit loss experience, the examiner should further check the reasonableness of management’s (reserve) methodology by comparing the reported (reserve) against the following amounts: (a)50 percent of the portfolio that is classified doubtful; (b)15 percent of the portfolio that is classified substandard; and (c)for the portions of the portfolio that have not been classified, estimated credit losses over the upcoming 12 months given the facts and circumstances as of the valuation date.”

According to the policy statement, the first two factors in the above reasonableness formula are based entirely on industry averages. The last factor is to be based on the institution’s average annual rate of net charge-offs over the previous 2 or 3 years. If this information is not available, then the examiner may use industry average net charge-off rates for nonclassified loans.

Consistent with FRB’s characterization, the policy statement says that the above formula is meant only as a reasonableness test to be applied by examiners. We do not agree with OTS’s statement that this formula provides specific guidance for the use of historical analyses. In addition, we believe the use of this formula by examiners or institutions could be misleading because it is based largely on industry averages. As previously mentioned, standard industry loss percentages do not consider the particular characteristics of the institution’s loan portfolio and, as demonstrated in the report, can result in overstated or understated reserves.

OCC did not cite the interagency policy statement in its comments regarding this or any other recommendation. OCC stated that it believes banks’ analyses should have an internal focus on the unique composition and historical loss experience of their own portfolios rather than on external comparisons with average experience of the industry. OCC also stated that because no single approach has been determined to be the best, it does not require banks to use a specific method or time period to determine their own historical loss experience. In addition, it stated that the method used will depend to a large degree on the capabilities of the individual bank’s information systems. OCC indicated that its examiners have been instructed, given the individual bank’s systems capabilities, to determine whether a bank’s methodology for evaluating the allowance produces reasonable estimates of probable losses which are inherent in its portfolio.

Similar to OCC, FASB interpreted this recommendation to be a request that it develop a specific method for using loss experience—for example, that the last 3 years of experience should be used to estimate current year losses. It believes banks should have the flexibility to use the historical data that are judged to be most reflective of its current loan losses. By developing a specific method for using historical experience, FASB believes that banks’ ability to use the most relevant data would be eliminated.

While we agree conceptually with FASB and OCC that banks should be given the latitude to use what they determine to be the most meaningful approach to establishing reserves based on historical losses, we believe that in practice such flexibility would likely result in significant under-reserving in times of economic decline and over-reserving in times of economic prosperity. In addition, as demonstrated in the report, major inconsistencies and therefore incomparability can result when institutions use methods which produce significantly varying amounts of reserves for the same loss exposure.

We believe such inconsistency and incomparability result, in part, from the lack of clarifying guidance by FASB related to the types of “existing conditions” referred to in SFAS No. 5 that are indicative of probable loan losses, as well as the lack of guidance on specific actions to be taken if “future events” confirming the losses fail to occur. We believe it is incumbent on FASB to provide clarification on these and other issues relating to the use of historical analyses to estimate probable loan losses.

Comments on Required Analyses and Supplemental Reserves

Regarding our recommendation that all portions of the reserve, including any supplemental amounts, should be directly linked to and justified by documented analyses, all regulators agreed that documentation was important, but there were significantly differing views on whether large supplemental reserves should be allowed. FASB did not believe it was responsible for providing the type of guidance we recommended, but agreed that the type of justification we described should support an appropriate estimate of reserves.

FDIC, FRB, and OTS all agreed that documentation of the reserve analyses was important, but they believed that the interagency policy statement provided sufficient guidance on the required level of documentation of reserves.

The interagency policy statement does state that the board of directors and management are expected to adequately document the institution’s process for determining adequate loan loss reserves. However, this language is not significantly different from that contained in prior regulatory guidance. We believe this level of guidance is too general, as demonstrated by the significant amounts of unjustified reserves discussed in the report.

With regard to our findings and conclusions on unjustified supplemental reserves, FDIC and FRB indicated that from a regulatory perspective, reserves should be more conservatively estimated in order to protect the deposit insurance funds. Therefore, they stated they would hesitate to suggest that an institution reduce its reserves, even if a reduction was indicated by the institution’s analyses of probable existing losses. We find this position to be contrary to their comments regarding the need for documented analyses to support the level of reserves, but consistent with the findings in the report.

As indicated in the report, over 30 percent of the total reserves of 7 of the 12 institutions we reviewed were supplemental reserves which were generally not justified by supporting analyses. As demonstrated in the report, unjustified supplemental reserves can not only mask the improvement of a loan portfolio in good times, but can also enable an institution to conceal increases in loss exposure during bad times. In addition, we believe these large unjustified supplemental reserves reflect institutions’ and regulators’ uncertainty as to how to best identify and measure probable losses in the loan portfolio—such uncertainty is likely to result in misstated reserves, especially when institutions rely heavily on supplemental reserves as “cushions” rather than doing the specific, comprehensive analyses necessary to identify existing probable losses. We do not believe that reserves should be used by regulators as cushions for future uncertainties or that such cushions should be commingled with reserves whose purpose is to reflect losses already existing in the portfolio. Further, we believe that if regulators are concerned about future losses, then direct capital appropriations could be made rather than using the loan loss reserve to address this concern.

In its comments on this recommendation, OCC stated it believes some margin for error is desirable, but that it shares GAO’s concerns about large supplemental reserves. It believes that reducing the relative size and importance of this unallocated component of the allowance will produce a more refined and reliable estimate of an appropriate reserve level in most banks. OCC also stated that it revised Banking Circular 201 in February 1992 and expects the long-term effects of this revised guidance, as well as the implementation of SFAS No. 114, to result in a reduction in supplemental reserves.

We analyzed the revised Banking Circular 201 in connection with our 1993 report on OCC bank examinations and also in connection with our work for this report. While the revised banking circular does provide sound general guidance, it does not provide for a methodology to quantify the various risk factors that are to be considered by banks and examiners in assessing the reserve. Therefore, we believe Banking Circular 201 still provides too much latitude in banks’ reserving practices.

As discussed in the report, SFAS No. 114 only addresses reserving for individual loans identified by the institution for evaluation of collectibility. It does not address overall reserving practices which encompass estimates of inherent, as well as specific, losses. Therefore, as stated in the report, we do not believe the application of SFAS No. 114 will resolve the problems we identified in the report with regard to supplemental reserves.

FASB’s comments on this recommendation indicated that while the type of analysis and documentation advocated by GAO should support an appropriate financial statement estimate, the form and detail is generally left to the institution and its auditor. It stated that FASB does not prescribe how an entity should demonstrate its compliance with GAAP.

While we agree that FASB should not be required to prescribe demonstration of GAAP compliance, we do believe it should develop or clarify GAAP standards when it becomes clear that existing guidance does not provide the desired result of consistent and reliable financial information. We believe the report clearly demonstrates that the desired result is not being achieved with regard to supplemental reserves and therefore that FASB needs to take action.