Loan Loss Reserves: Balancing Accounting Transparency and Bank Safety, Study notes of Accounting

Download Loan Loss Reserves: Balancing Accounting Transparency and Bank Safety and more Study notes Accounting in PDF only on Docsity! The recent fi nancial crisis has prompted an evaluation of many aspects of banks’ fi nancing and accounting practices. One area of renewed interest is the appropriate level of loan loss reserves, the money banks set aside to off set future losses on outstanding loans.1 Deter- mining that level depends on balancing the requirements of bank regulators, who empha- size the importance of loan loss reserves to protect the safety and soundness of the bank, and of accounting regulators, who emphasize the transparency of fi nancial statements. Loan loss reserves appear in two places in a March 2012, EB12-03 Economic Brief EB12-03 - The Federal Reserve Bank of Richmond Loan Loss Reserve Accounting and Bank Behavior By Eliana Balla, Morgan J. Rose, and Jessie Romero The rules governing banks’ loan loss provisioning and reserves require a trade-off between the goals of bank regulators, who emphasize safety and soundness, and the goals of accounting standard setters, who emphasize the transparency of fi nancial statements. A strengthening of accounting priorities in the decade prior to the fi nancial crisis was associated with a decrease in the level of loan loss reserves in the banking system. Page 1 bank’s fi nancial statements: the balance sheet (Figure 1) and the income statement (Figure 2).2 Outstanding loans are recorded on the asset side of a bank’s balance sheet. The loan loss reserves account is a “contra-asset” account, which reduces the loans by the amount the bank’s managers expect to lose when some portion of the loans are not repaid. Periodically, the bank’s managers decide how much to add to the loan loss reserves account, and charge this amount against the bank’s current earnings. This “provision for loan losses” is recorded as an expense item on the bank’s income statement. Balance Sheet as of December 31, 2011 Hypothetical Bank (thousands of dollars) Assets Liabilities and Equity Cash $ 8,000 Deposits $ 74,000 Securities 20,000 Other liabilities 19,000 Total loans $ 64,000 Total liabilities $ 93,000 Less: Reserves for loan losses 1,000 Equals: Net loans 63,000 Other real estate owned 400 Owners’ equity 7,000 Other assets 8,600 Total assets $ 100,000 Total liabilities and owners’ equity $ 100,000 Figure 1: Hypothetical Bank Balance Sheet Page 2 A relatively large accrual for commercial banks, loan loss provisions have a signifi cant eff ect on earnings and regulatory capital. Because loan loss provisions are at the discretion of bank managers, there is the potential for banks to provision more or less than necessary as a way to smooth their income. From an accounting perspective, this could introduce discre- tionary modifi cations to banks’ earnings and reduce the comparability of results across fi rms. On the other hand, higher provisioning might in- stead refl ect a more cautious approach to building up reserves prior to future losses. From a prudential perspective, income smoothing could reduce the negative impact of asset volatility on bank capital. It also could reduce banks’ procyclicality, since loan loss provisioning potentially creates a feedback mechanism between the fi nancial and real sectors of the economy. If banks do not have suffi cient reserves to absorb losses when economic conditions worsen, they must rapidly increase their provisioning, which could cause them to curtail lending and potentially prolong the downturn.3 Accounting Goals and Regulatory Goals According to the accounting guidelines established by the Financial Accounting Standards Board (FASB), banks may increase their loan loss reserves when it becomes highly probable that a loss is imminent, and if the amount of that loss can be reasonably estimated. One rationale for these guidelines is to prevent banks from using the loan loss reserves to smooth their earnings: A bank could shift income from good quarters to bad quarters by taking large provisions when income is high and small provisions when income is low. Managing earnings in this way could help publicly held banks maintain higher stock prices, and help bank managers meet their compen- sation targets. Empirical studies suggest that banks have used loan loss reserves to manage income,4 and that prior to rules changes in the 1980s and in 1990, banks also used their loan loss reserves to gain more favorable tax treatment and to manage their capital positions.5 Despite the potential to use loan loss reserves to achieve objectives other than ensuring safety and soundness, prudential considerations suggest that higher reserves, all else equal, enable the bank to ab- sorb greater unexpected losses without failing. This would involve a more forward-looking approach to loan loss provisions that factors in future losses due to changing economic conditions, even if an event that would make losses likely has not yet occurred. In addition, the “event-driven” accounting approach does not refl ect the fact that a booming economy tends to be accompanied by more risk-taking in lending and relaxed underwriting standards, poten- tially generating bad loans that won’t be revealed until the boom ends. As noted above, the accounting guidelines for loan loss reserves could make banking more procyclical. If loan loss reserves are relatively low during good times, banks would have to rapidly increase their loan loss provisioning when an economic downturn occurs and defaults become more common.6 But Income Statement for Year Ending December 31, 2011 Hypothetical Bank (thousands of dollars) Interest income Interest and fees on loans $ 7,000 Interest on securities 1,800 Other interest income 200 Noninterest income Service charges 400 Other noninterest income 600 Total income Interest expense Interest on deposits $ 4,000 Other interest expense 2,000 Noninterest expense Salaries and benefi ts 1,000 Provision for loan losses 300 Other noninterest expense 1,700 Total expense Income before taxes $ 1,000 Income taxes 250 Net income $ 750 Figure 2: Hypothetical Bank Income Statement $ 9,000 $ 10,000