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This article, based on one of three panelists' presentations during one session of RMA's Capital Management Conference, looks at the issues surrounding guidance from the SEC and FASB on loan loss reserves, as well as the convergence of loan loss reserves and economic capital. While the author admits he does not have all the answers, the intent is to encourage more structured consideration of the issues.

In July 2002 the EFLEC and SEC issued a joint statement providing guidance on the design and implementation of loan loss methodologies and supporting documentation practices, including the following points:

* It set forth the need for allowance processes to be thorough, disciplined, and consistently applied.

* It recommended processes for maintaining and documenting allowance policies and procedures.

* It set a very clear mandate for board responsibility in ensuring control of processes to determine an appropriate allowance level.

* It called for greater transparency in the calculation estimation of the allowance. Meanwhile, the AICPA published a draft of a position statement, being prepared for final release in late 2003, which states that individual loan impairment should be just one component of the allowance, recognized and measured pursuant to FAS 114 (Accounting by Creditors for Impairment of a Loan--a,, amendment of FASB Statements No. 5 and 15, May l993 (1)). There should be additional components for collective loan impairment recognized under FAS 5 (Accounting for Contingencies, March 19752), which constitute the pooled reserves.

Industry Concerns

Creditors are expected to group loans into risk pools with similar characteristics other than those that were individually evaluated under FAS 114. The new guidance provides clarity on FAS 5. Attributes considered in the allowance should be supported by observable data relative to the specific loss attributes. Pooled reserves should be directionally consistent with changes in the related observable data. This is new thinking, and the key is to view reserves in terms of changing economic and industry conditions. Clearly, as credit risk increases, reserves should increase as well.

Bankers are waiting for some answers despite the most recent guidance. The new SEC guidance may not define the loss event (default) and may not link the estimation of unexpected losses with expected losses. In addition, the guidance may not define the time period of losses. Nor does it tell us how many months of losses should be held in reserve. For example, should it be 12 months, the remaining life of the loan, or the contractual life of the loan?

Further, the new guidance does not permit the use of future loss models or the establishment of reserves using peer/industry averages. Although future losses may be 100% certain, those future losses cannot be accrued before they have been incurred. For example, PNC has a fairly reliable model for estimating loss given default and expected loss relative to HELOCs. Under this guidance, that model cannot be used to estimate current loan loss; rather, LGD and EL must be taken as the losses occur.

Credit losses are typically volatile and difficult to quantify, which leads to imprecise support--the so-called documentation challenge, which is a key industry challenge going forward. Also, numerous firms are migrating to evaluating and managing allowances, as a complement to capital, yet the SEC guidance does not consider loan losses or their relationship to capital in any respect.

Also, there appears to be no clear guidance on loss events and no clear guidance on loss timelines. One of the most significant unanswered questions revolves around the lack of guidance on unallocated reserves under GAAP. In a strict sense, it is pretty clear that unallocated reserves would not be permitted, since they do not meet the criteria under FAS 5 or FAS 114. The sense is that the SEC wants banks to take a pay-as-you-go approach.

There are two other primary industry concerns. First, the quarterly fluctuations in a bank's asset quality will distort allowances and create more earnings volatility versus a more normal, smoother-through-the-cycle approach. Second, shareholders increasingly view the allowance as a capital component--and as such, the market will prefer less allowance volatility.

Convergence

There definitely is a growing convergence between allowances for loan loss and economic capital. The modeling advances that a number of banks have made over the past several years are leading to a greater degree of confidence, particularly in making decisions from the output, both from an economic capital standpoint and a loan loss allocation standpoint.

The regulatory capital required in Basel II's Advanced Approach is driven by the same risk parameters as the reserve methodology--probability of default, loss given default, and expected default. The PNC models that we use on a quarterly basis to drive our loan loss evaluation decisions are the same types of models we're developing with respect to Basel. The expected loss component clearly is the same, so we are looking at a natural convergence. In addition, expected losses that we're calculating for capital purposes and unexpected losses are parts of the same continuum, yet the more recent pronouncements coming from the FASB and the SEC do not seem to recognize this.

However, there remain some potentially large differences. Bankers and regulators to a large extent still want to retain that unallocated reserve component. As mentioned earlier, the very strict definition within the SEC guidance indicates that unallocated reserves should be part of unexpected loss, that is, a component of capital. There also are differing applications of common risk parameters, for example, the loss given default horizons (one year or life of the loan) that we use and how migration analysis figures into the overall evaluation.

Finally, Basel II proposes that both unexpected losses and expected losses be included in bank capital; including both capital and reserves seems like double counting. Also, the Basel definition of capital may be inconsistent with GAAP, as it mixes accounting concepts with measurements of risk. It's important to bear in mind that Basel continues to use two different balance sheet components as capital--Tier 1 and total capital, which includes subordinated debt--neither of which approximates the balance sheet concept of capital that risk practitioners compare or use, with their internal estimates of economic capital. This reminds me of a back-to-the-future 1980s view of the old-time primary capital definition. That's a significant difference in terms of how bank risk management practitioners are looking at it and how the regulators might look at it.

Back to the Future

So what's next from an industry perspective? It's clear that with the confluence of events--Basel II, SEC and FASB actions, and recent actions of the International Accounting Standards Board--there is a need to see greater convergence of the accounting and regulatory guidance with respect to loan loss reserves and economic capital. As a former regulator, I can see both sides of the problem. Also, there are differences between the agencies in terms of how they view this. So not only do we need convergence between accounting and regulatory opinion, but clearly we also need it among the regulatory agencies themselves.

Notes

(1.) /www.fasb.org/st/summary/stsum114.shtml

(2.) www.fasb.org/st/summary/stsum5.shtml

(3.) www.sec.gov/interps/account/sabl02.htm

[c] 2003 by RMA. Jo/in Wixted is chief regulatory officer at PNC Bank, NA, Pittsburgh, Pennsylvania. Before joining PNC Bank, Wixted was senior vice president at the Federal Reserve Bank of Chicago for six years; before that, he was at the Federal Reserve Bank of Cleveland.

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