The issue of whether banks are using their loan loss reserves to manage earnings reached an uncomfortable point for bankers last week when an explanation of the relevant generally accepted accounting principles (GAAP) was posted on the Internet. In fact, it appears banks have loosely interpreted the rules, but the Security and Exchange Commission’s ruling on their accounting behavior may be awhile.

The issue is of particular importance to banks, which were once viewed as very volatile in terms of earnings due to their dependence on interest rates. Banking regulators gave the go-ahead to build up reserves several years ago, providing banks with a cushion when unexpected losses occur. Last fall, the SEC questioned the legitimacy of those cushions, and then backed off when the industry cried unfair.

Last week, Financial Accounting Standards Board posted an article on its Web site interpreting financial accounting statements 114 and 5. While there is still room for a special task force from the American Institute of Certified Public Accountants (AICPA) to clarify how to reserve for possible bad loans and remain within GAAP, the FASB staff’s interpretation provides guidance that industry sources said was not apparent to bankers before. An example is the observation that a loss must be incurred before it can be written down, which sources said is generally not the approach today. Instead, there now is a liberal interpretation of FAS 5, which holds that a loss has occurred once a borrower enters prolonged financial trouble, not when bankruptcy occurs.

"It could have a serious effect on the amount of allowances banks could have. This comes out hours or days before people put out first quarter earnings and file 10Qs," said one source at top-five accounting firm.

A FASB staffer said, however, that "nobody’s particularly arguing it needs to be applied retroactively."

Nevertheless, bankers contacted by Financial Modernization Report were eager to hear from the SEC, which ultimately enforces the accounting. SEC staffers said that the agency was waiting for someone–specifically, a bigfive accounting firm–to ask them for the guidance on when, how and by how much to revise allowances.

But even then it may be awhile before the SEC acts, according to staffers, because Lynn Turner, the chief accountant, has been out of the office, and because the issue is a complex one.

"This is going to take a couple of weeks. I haven’t fully thought this out. Usually those things are treated prospectively, or by cumulative catchup," where a bank recognizes the effect of the change in one line below net income and before cumulative effect on the financials. The staffer added that the possibility of restatement was practically nil. Further, he said, the staff might have to turn around and consult with FASB on the issue and even the top five accounting firms. "We’d really need to understand the extent of the problem before we come up with a solution," he said.

Meanwhile, the AICPA is scheduled to meet April 20 to continue studying implementation issues and work on a proposed statement of position on how to apply GAAP to loan reserves. The proposal must be approved by both FASB and the AICPA’s Accounting Standards Executive Committee.

Pascal Desroches, SEC accounting fellow and member of the task force, said the issue of when a loss is incurred may appear straightforward but, in fact, is complicated. As an example, he cited the differing opinions on a bank allowing for the default of a corporate borrower due to Y2K problems. "Some may say if the borrower hasn’t fixed the bug, then it’s a fair allowance. But some would say whether or not they fix this bug is a future problem; the company hasn’t gone bankrupt, therefore you can’t provide an allowance."

One controller at a major regional bank voiced a popular opinion when he said he hoped FASB’s interpretation merely means regulators are "sensitizing everyone to put more discipline in the process. We’re not going to change the world, but we’re going to control the current situation. We’ll keep an eye on you. You better tighten up your documentation (of the rationale for reserving for loans that have not defaulted yet but are expected to.)"

International banking supervisors are considering raising capital requirements on loans to developing countries and hedge funds, a senior regulator said recently.

The new system would use bond ratings to determine the capital charge on loans to sovereign governments, said Stephen C. Schemering, deputy director of banking supervision at the Federal Reserve Board.

Reserves would not be required for loans to countries with the top credit ratings, such as AAA or AA-minus, he said. Credits to countries with A- plus or A-minus ratings could carry a 20% risk weighting, he said. That means the bank would hold 20% of the standard 8% capital charge, or 1.6% of the loan, as a reserve. Countries with very low credit ratings could be subject to a 150% risk weighting, which translates into a 12% capital charge, he said.

International regulators also are considering a 150% risk weighting for loans to "highly leveraged institutions not subject to regulation," Schemering said during a workshop at the Independent Bankers Association of America convention. That is how regulators typically describe hedge funds.

The 150% risk weighting also would apply to "impaired" loans, though he provided little detail on what it would take for a credit to be considered impaired.

Schemering cautioned that the proposal is a draft and significant changes could be made before its expected release next month. Yet this would be the first time international regulators ever set capital requirements above 8%.

The capital proposal also would change the treatment of loans to other banks and securities firms, Schemering said. The reserve requirement would be one risk bucket higher than the capital charge for loans to the borrowing bank’s home country government, he said.

That means a loan to a U.S. bank would be subject to a 20% risk weighting. Mortgage loans would continue to fall into the 50% risk bucket, he said. Regulators plan to continue to require the full 8% reserve on all corporate loans, though Schemering said there is some talk of discounting the required reserve for loans to AAA-rated companies.

The Securities and Exchange Commission’s recent crackdown on earnings management, reported widely several weeks ago, may be little more than a warning, but it may also be ammunition.

The agency sent a letter to select bank holding companies last month telling them that it might investigate their banks’ loan-loss reserves.

The SEC has let it be known that it is not happy with the generous loan-loss reserves banks have set aside for a rainy day, viewing them as a form of earnings management rather than healthy prudence, and so against generally accepted accounting principles (GAAP). The conundrum this creates for banks is that the banking regulators want to see the strong allowances. The situation came to a head this fall when SunTrust was required to restate earnings to the tune of several million dollars.

The letter, which was addressed to a generic "Chief Financial Officer," advised that the banks’ 1998 annual reports "may be selected for review." The language was so seemingly casual that some analysts saw it as an almost friendly admonition to follow GAAP.

"So it’s not a ‘we’ve looked at your charges and disagree with them’ (letter); it’s a kind of a reminder letter. I think long term this is just a friendly reminder, ‘The accounting rules are there, follow them.’ This is just pulling the boys in," said Hal Schroeder, senior bank analyst at Keefe Bruyette & Woods.

Other bank watchers were not so sanguine.

"This is like a comment letter in advance," said Michael Joseph, partner at Ernst & Young. "This could be ammunition for the SEC for those they feel haven’t complied, (the agency can say) ‘We told you already.’ These are things the SEC is looking to see in this year’s annual reports and I will expect banks to be criticized if they don’t comply."

Banks must file annual reports by March.