Accountants at banks may have to change the way they count the beans that could go bad.

The Financial Accounting Standards Board (FASB) is considering a new method for calculating reserves as part of a sweeping proposal that has gotten more attention for its fair-value mandate. The new method would be the biggest change to reserving practices in more than three decades, experts said.

Some in the industry favor the proposal, which would require banks to set reserves based on long-term loss expectations rather than wait for possible signs of imminent default. The advantage, they said, is that balance sheets would more accurately portray the present value of cash flows expected to be collected.

Opponents argue that the plan would front-load credit costs, which would also reduce income and pressure capital, without empowering banks to pad reserves during good times. All agree that neither plan fully removes subjectivity from reserving methods, which already vary among banks.

"There is likely to be a huge and immediate charge" to the bottom line if the changes are implemented, said Dorsey Baskin, a partner in the national professional standards group at Grant Thornton. "That's because you would be taking an allowance based on past losses and include more reserves for future losses."

To make their point, experts offered an example of a $10 million credit card portfolio with an expected loss rate of 5% per year over three years — or $1.5 million — based on economic conditions in the financial statement period.

Under the existing "incurred loss" model, banks are only allowed to add to reserves when they can point to an event that indicates that a loss has happened at the financial statement date, such as a borrower's job loss, bankruptcy filing or hospitalization. The event also can be something broader like the closure of a big employer in a community or an uptick in unemployment. Reserves are built — or released — quarter by quarter by taking the recorded amount of the loan and subtracting expectation of unrecovered funds, and it must assume a continuation of existing economic conditions.

The already incurred losses in the $10 million portfolio might be only, say, $250,000 to $500,000, at the financial statement date. Reserves would change as the economy deviates from that assumption and as new loss-causing events occur.

The FASB proposal would shift more toward an "expected loss" model. Using the same credit card analogy, banks would have to reserve for the entire $1.5 million of expected losses in the quarter that the loans were made. Over time they would also have to put the interest income on those losses into reserves, which would further reduce the bottom line.

As with the incurred model, the expected loss amounts would have to take into account existing economic conditions. The reserve would need to be adjusted if at some point the expected loss rate deviates from the original 5% assumption because of changes in economic circumstances.
Tim Yeager, a former Federal Reserve economist who is now a finance professor at the University of Arkansas, said he approves of the new method. "I think it is more realistic and makes the system stable over the long run," he said. "I see having more reserves as leading to more smoothing, which I see as a good thing."

Donna Fisher, a senior vice president at the American Bankers Association, agreed that the existing model must be improved "to include more forward-looking losses." Fisher said, however, that there are many ways to address the issues and that the ABA wants to work with the FASB "to develop a solid model."

Wells Fargo has already filed a comment on the proposal, saying it supports "an impairment model that allows for earlier recognition of expected credit losses."

Some banks have wanted a bias toward larger reserves to limit the need for building them up, thus reducing volatility. Such an approach backfired in 1998, when the Securities and Exchange Commission (SEC) forced SunTrust Banks to restate three years of earnings after determining that the Atlanta company had over-reserved. Though the SEC never took a formal enforcement action against the SunTrust in that matter, the agency had claimed that the moves were meant to help SunTrust manage net income.

Critics of the proposed change argue that it perhaps introduces even more subjectivity by giving banks the ability to use expected losses to determine what they reserve. They also argue that the plan, much like the current model, still prevents banks from adding to the loan-loss allowance during good times.

"In theory the new proposal is subject to more guesstimates," said Dennis Beresford, a University of Georgia accounting professor who was the chairman of the FASB from 1987 to 1997. "Will there be sufficient systems and procedures and can it be done reliably?"

Each has significant discretion that falls well short of a "bright line" standard, according to one accounting executive for a big banking company. "Of all the numbers on an income statement, the allowance is the most subjective and relies heavily on management discretion," said the executive, who asked not to be named. "There is no hard-and-fast approach."

Jon Chism, a partner at the accounting firm Plante & Moran, also argued in a recent blog post that changing systems and procedures would create significant challenges for smaller banks. "Such a shift would create new requirements for valuing loan portfolios, which translates into higher expenses — and more time — for banks," he wrote.

"Perhaps more importantly, moving to an expected loss basis could necessitate that banks tie up more capital for loan-loss reserves, causing greater friction between their regulators and further impacting their balance sheets," he said. A call to Chism for further comment was not immediately returned.

Adding to the uncertainty is the surprise retirement of FASB Chairman Robert Herz and plans to expand the size of the entire board. Meanwhile, the International Accounting Standards Board has its own proposal that would require adjustments to yields rather than an up-front reserve build.

Perhaps the biggest challenge remains the fact that the proposal is embedded within the plan to enact fair-value accounting, which has far more resistance from the banking industry and seems more controversial within the FASB itself.

Beresford predicted it is unlikely that the entity would separate and vote on the two issues, linking the fate of one change to the other. "I don't think the FASB will carve out anything," he said.

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