In his testimony today, long-time industry pariah Simon Johnson took on practices that, he said, are leading many banks to “gamble for resurrection.” Mr. Johnson of course took on big banks, but the focus of the hearing and his testimony – Congressional measures to force supervisors to ease up on small banks – is an important reminder that significant risks – including systemic ones – aren’t confined to SIFIs. Mr. Johnson rightly opposed the cures small banks pressed for the seeming ill of over-stringent supervisors. But, there’s a better solution to the ongoing failure to recognize growing credit risk than either community banks or Mr. Johnson advocated: fix the way reserves are included in regulatory capital. Thereby, we think, one would simultaneously improve safety and soundness and reduce the need for ever more punitive capital add-ons.

The hearing focused on two bills to ease up on small banks. Bigger ones might get a bit from the first of them, a proposed rewrite of accounting standards governing when a loan must be classified as non-accrual, but the concept isn’t of their doing. Rather, it comes from small institutions that argue that accounting rules are unduly stringent because small banks know good customers when they see them. We might be tempted to agree with this if small banks had shown better judgment when real-estate developers walked in the front door. Now that the borrowers are by the kitchen door begging for a hand-out, the ability of these same bankers to make disciplined judgment about long-term ability to repay is, at best, questionable.

If Congress cooks the books, “extend-and pretend” – that is, regulatory sanction to think only happy thoughts – will grow from a serious problem to a systemic risk. Regulators so far have allowed large banks to put the smiley face on second liens, even as they’ve countenanced a lot of go-slow on recognizing risk in the real-estate development books – often huge – at smaller institutions. Changing by magic even worse performing loans that are now on non-accrual and calling them miraculous accrual ones would turn “extend and pretend” into “duck and cover”.

There is, though, one very constructive change to accounting to which FASB should quickly attend. It has to do with the definition of loss for purposes of setting reserves. As the OCC has taken the lead in pointing out, the current approach is badly broken. Banks can only book reserves for incurred loss, not those they expect. Not that banks are all that good at expecting loss – see above – but the current approach to reserving gives them no reason to get any better at it. And, worse, the treatment of reserves in capital means that banks are under-capitalized in real terms for likely loss.

In Basel I and, then, II and, now, III, reserves count for only a limited amount of Tier 2 regulatory capital. Over the decades, regulators recognized that this treatment of reserves is counter-productive from a prudential perspective, but they’ve put the issue off for another day at every Basel rewrite. In large part, reluctance to address reserves derives from the theoretical view – right in concept – that capital should cover unexpected loss, while reserves handle expected loss and, thus, should be segregated from capital. But, this theoretical rationale is wrong in practice.

First, as noted, reserves don’t handle expected loss because accountants won’t let banks treat them with the honesty these risks require. But, the second reason why reserves should be recognized in the capital calculation is even more compelling. In the recent crisis, many banks went from seemingly well-capitalized status to collapse in a dizzying downward spiral. It’s in part for this reason that bank regulators – see the SIFI surcharge as a case in point – are scurrying to hike regulatory-capital ratios. But, doing so only papers over the lack of adequate reserves with a high-cost capital buffer that might still be insufficient under stress.

For all the claims of counter-cyclicality in the new Basel III standards, they still rely on risk modeling. If reserves are rightly reckoned and, then, appropriately recognized in regulatory capital, two important goals will be achieved: first, banks will be far better buffered from credit risk and, perhaps even more important, regulators won’t need to force ever higher capital ratios in hopes of a still-elusive way to bullet-proof banks big and small. Reserves will be sufficient for expected loss so capital can truly be on hand when the unexpected occurs.

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