Testimony Of
Donna Tanoue
Chairman
Federal Deposit Insurance Corporation
Allowances For Loan And Lease Losses
Before The
Subcommittee On Financial Institutions And Consumer Credit
Committee On Banking And Financial Services
U.S. House Of Representatives
10:00 A.M., June 16, 1999
Room 2128, Rayburn House Office Building
Good morning, Madame Chairwoman and Members of the Subcommittee. I appreciate
this opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC)
regarding recent developments affecting the accounting for the allowance for loan and
lease losses (loan loss reserves) by financial institutions. The banking and thrift
agencies and the Securities and Exchange Commission (SEC) have been engaged in
an ongoing dialogue on this issue. Our current work consists of a number of interagency
projects dealing with the appropriate methodologies and procedures for establishing
loan loss reserves, consistent with generally accepted accounting principles (GAAP).
Our objective in undertaking this work is to improve the transparency of financial
information and improve market discipline, consistent with safety and soundness.
Your letter of invitation asked that we discuss the coordination of, and progress made
by, the SEC and the banking and thrift agencies on establishing clear guidance for
financial institution loan loss reserves under GAAP. As you are aware, I joined with
Comptroller Hawke and Director Seidman in sending a letter to the House and Senate
Banking Committees indicating our concerns regarding this issue, specifically on a
recent Financial Accounting Standards Board (FASB) article published in Viewpoints.
The FDIC was concerned that financial institutions would interpret this Viewpoints article
in isolation from other guidance on loan loss reserves and would take this guidance as a
signal to make unwarranted reductions in loan loss reserves that could threaten bank
safety and soundness.
In my testimony today, I will discuss why adequate reserves remain a regulatory priority.
Next, I will address the ongoing dialogue between banking regulators and the SEC on
providing guidance to financial institutions ensuring that the level of reserves is
consistent with GAAP. Finally, I will outline the FDIC’s concerns regarding the
Viewpoints article. Responses to the specific questions raised in your letter of invitation
are attached to this statement in Appendix 1.
The Importance of Adequate Loan Loss Reserves
Donna Tanoue
Chairman
Federal Deposit Insurance Corporation
Allowances For Loan And Lease Losses
Before The
Subcommittee On Financial Institutions And Consumer Credit
Committee On Banking And Financial Services
U.S. House Of Representatives
10:00 A.M., June 16, 1999
Room 2128, Rayburn House Office Building
Good morning, Madame Chairwoman and Members of the Subcommittee. I appreciate
this opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC)
regarding recent developments affecting the accounting for the allowance for loan and
lease losses (loan loss reserves) by financial institutions. The banking and thrift
agencies and the Securities and Exchange Commission (SEC) have been engaged in
an ongoing dialogue on this issue. Our current work consists of a number of interagency
projects dealing with the appropriate methodologies and procedures for establishing
loan loss reserves, consistent with generally accepted accounting principles (GAAP).
Our objective in undertaking this work is to improve the transparency of financial
information and improve market discipline, consistent with safety and soundness.
Your letter of invitation asked that we discuss the coordination of, and progress made
by, the SEC and the banking and thrift agencies on establishing clear guidance for
financial institution loan loss reserves under GAAP. As you are aware, I joined with
Comptroller Hawke and Director Seidman in sending a letter to the House and Senate
Banking Committees indicating our concerns regarding this issue, specifically on a
recent Financial Accounting Standards Board (FASB) article published in Viewpoints.
The FDIC was concerned that financial institutions would interpret this Viewpoints article
in isolation from other guidance on loan loss reserves and would take this guidance as a
signal to make unwarranted reductions in loan loss reserves that could threaten bank
safety and soundness.
In my testimony today, I will discuss why adequate reserves remain a regulatory priority.
Next, I will address the ongoing dialogue between banking regulators and the SEC on
providing guidance to financial institutions ensuring that the level of reserves is
consistent with GAAP. Finally, I will outline the FDIC’s concerns regarding the
Viewpoints article. Responses to the specific questions raised in your letter of invitation
are attached to this statement in Appendix 1.
The Importance of Adequate Loan Loss Reserves
Banking and thrift regulators must ensure that financial institutions maintain appropriate
resources to absorb losses arising from the business of banking. Equity capital, which
consists of accumulated retained earnings and funds paid-in by shareholders, serves as
the last line of defense for the deposit insurance funds and is the primary means by
which we can ensure that the insurance funds will not be depleted, necessitating a call
for taxpayer dollars. After the problems experienced by the industry during the 1980s,
the Congress recognized the importance of adequate capitalization by enacting
legislation on such issues as risk-based capital and prompt corrective action standards.
Banking and thrift regulators must also ensure that the accounting principles used by
financial institutions adequately reflect prudent and realistic measurements of assets
among other items. Any losses imbedded in the asset portfolio should be accurately
presented in order to reflect properly the amount of an institution’s equity capital.
Probably the most important adjustment in reflecting the carrying value of the loan
portfolio, and the focus of the hearing today, is loan loss reserves. Loan loss reserves
are created as a result of losses incurred from one of the principal risk areas in banking
-- credit risk arising from lending activities.
To determine an appropriate allowance, financial institutions must periodically evaluate
the loans held in their portfolios to determine the likelihood of collection. In cases where
it is probable that a loan or group of loans will be not fully collected and the impairment
is reasonably estimable, institutions are required to establish a reserve and recognize a
loss against current earnings. When a loan is identified as uncollectible, the amount is
charged against the allowance account. However, if the institution then suffers
additional credit losses and must increase its reserves, this will be an expense to
current earnings and, therefore, a reduction in equity capital. Thus, establishing the
appropriate level for the allowance account is of great concern to banking and thrift
regulators. Conceptually, loan loss reserves should represent credit losses inherent in
an institution’s loan portfolio given the facts and circumstances as of the evaluation
date. Protection against credit losses that have not yet been incurred should be
provided through the institution’s equity capital.
The FDIC, primarily through its examination process, emphasizes the need for banks to
maintain prudent and conservative, but not excessive, loan loss reserves that fall within
an acceptable range of estimated losses determined in accordance with GAAP.
Establishing appropriate levels for loan loss reserves is an art, not a science. Trying to
clarify the precise methodology for setting reserves, which I will address below, is also a
difficult and judgmental task. Both the banking and thrift agencies and the SEC agree
that the process for determining reserves must be based on a comprehensive,
adequately documented, and consistently applied analysis of the loan portfolio. We
agree wholeheartedly with the SEC that the process must not be misused to manipulate
earnings or mislead users of financial statements.
Recent developments in the current economic climate suggest that some institutions
may need to review the loss assumptions built into their loan loss reserve calculations.
Such developments include the economic difficulties in Asia and Brazil, weaknesses in
resources to absorb losses arising from the business of banking. Equity capital, which
consists of accumulated retained earnings and funds paid-in by shareholders, serves as
the last line of defense for the deposit insurance funds and is the primary means by
which we can ensure that the insurance funds will not be depleted, necessitating a call
for taxpayer dollars. After the problems experienced by the industry during the 1980s,
the Congress recognized the importance of adequate capitalization by enacting
legislation on such issues as risk-based capital and prompt corrective action standards.
Banking and thrift regulators must also ensure that the accounting principles used by
financial institutions adequately reflect prudent and realistic measurements of assets
among other items. Any losses imbedded in the asset portfolio should be accurately
presented in order to reflect properly the amount of an institution’s equity capital.
Probably the most important adjustment in reflecting the carrying value of the loan
portfolio, and the focus of the hearing today, is loan loss reserves. Loan loss reserves
are created as a result of losses incurred from one of the principal risk areas in banking
-- credit risk arising from lending activities.
To determine an appropriate allowance, financial institutions must periodically evaluate
the loans held in their portfolios to determine the likelihood of collection. In cases where
it is probable that a loan or group of loans will be not fully collected and the impairment
is reasonably estimable, institutions are required to establish a reserve and recognize a
loss against current earnings. When a loan is identified as uncollectible, the amount is
charged against the allowance account. However, if the institution then suffers
additional credit losses and must increase its reserves, this will be an expense to
current earnings and, therefore, a reduction in equity capital. Thus, establishing the
appropriate level for the allowance account is of great concern to banking and thrift
regulators. Conceptually, loan loss reserves should represent credit losses inherent in
an institution’s loan portfolio given the facts and circumstances as of the evaluation
date. Protection against credit losses that have not yet been incurred should be
provided through the institution’s equity capital.
The FDIC, primarily through its examination process, emphasizes the need for banks to
maintain prudent and conservative, but not excessive, loan loss reserves that fall within
an acceptable range of estimated losses determined in accordance with GAAP.
Establishing appropriate levels for loan loss reserves is an art, not a science. Trying to
clarify the precise methodology for setting reserves, which I will address below, is also a
difficult and judgmental task. Both the banking and thrift agencies and the SEC agree
that the process for determining reserves must be based on a comprehensive,
adequately documented, and consistently applied analysis of the loan portfolio. We
agree wholeheartedly with the SEC that the process must not be misused to manipulate
earnings or mislead users of financial statements.
Recent developments in the current economic climate suggest that some institutions
may need to review the loss assumptions built into their loan loss reserve calculations.
Such developments include the economic difficulties in Asia and Brazil, weaknesses in