Earlier this week, the International Accounting Standard Board brought its exhausted self over the finish line after a five-year consultation and revised the rules for loan-loss reserves. FASB will soon do the same on these shores, with each new rule tackling the critical question of how much banks should hold in reserves against the proverbial rainy day. With these new accounting rules, we should return to an unanswered question: the relationship between loan-loss reserves and regulatory capital. Pulling your green eye-shades down for a nap? Best take them off – the billions at stake in this question will drive the ability of banks not just to be safe and sound, but also to make loans.
The confusion between capital and reserves derives from the initial distinction — long outdated — regulators saw between them when the Basel rules first were crafted in the mid-1980s. Capital then and now is for unexpected loss and reserves were to take care of the expected ones. In the 1980s, this made sense. Capital then was premised on simple leverage requirements that cushioned banks against risk in even the safest assets; Basel I built proxy leverage standards through very simple risk weightings designed to impose at least some capital on all the recalcitrant countries that wouldn’t cotton to leverage standards..
In contrast, reserves were set as a small cushion against all loans – the general reserve was comparable in many ways to leverage capital, but a lot smaller and a charge to up-front earnings, unlike capital. Banks, though, were also required to hold specific reserves – that is, a pool of reserved earnings based on the incurred loss anticipated when a good loan goes bad.
The new reserve accounting rules changes the old “incurred” model to an “expected” one. This resolves a longstanding difference of opinion between bank regulators and accountants. Bank regulators always want banks to hold the largest amount of loan-loss reserves to make the bank as bullet-proof as possible – a reasonable policy objective. Accountants and securities regulators, however, rightly worried that big reserves could all too easily be “cookie jars” in which banks could put or withdraw funds to smooth earnings. Freddie Mac — once known as “steady Freddie” was the poster child for earnings management until caught at the start of the GSEs’ long decline into the crisis that overtook it in 2008.
The debate between bank and securities regulators was settled the way a hurricane can simplify home-improvement decisions: it was so clear that banks were hugely under-reserved that a shift from incurred to expected loss was a critical policy objective. The Group of Twenty pronounced this shift in its first list of post-crisis to-dos and so the accounting regulators at long last have acted.
Of course, reserving isn’t the only post-crisis change – Basel III mandates a new leverage rule, risk weightings have gotten a lot more complex, and the U.S. is also implementing an enhanced supplementary leverage rule in concert with G-SIB surcharges to top it all off. This capital construct is a combination of buffers against both expected and incurred loss – in essence, it’s shareholder money ahead of reserves designed, at least for credit risk, to do a good deal of what general and even specific reserves are supposed to.
This confusion is well-understood. In fact, the Basel rules permit banks to count a limited amount of reserves in their Tier 2 capital. They also have repeatedly said that, when the reserve question is resolved to their satisfaction, they will revisit the relationship between capital and reserves. With IASB’s action and FASB’s soon to follow, the time to take this on is now.
There are many reasons to recommend both capital and reserves, but each comes at considerable cost. This cost has major consequences, especially in terms of credit availability. Good rules are right and good rules are tough. But regulatory pile-ons have perverse public-policy and macroeconomic consequences. Regulators are, of course, weary of Basel III and reserve requirements. Still, they need quickly to right the balance between capital and reserves to ensure banks remain the effective financial intermediaries on which markets still depend.