Adequate Reserves and Other Hot Buttons

by Jeffrey K. Bagby, Regional Examiner, Oklahoma State Banking Department

We try to buffer it a bit when we discuss them with bankers. "Well, you know, it was Bert Lance that brought that on. . .. Those are just new accounting rules for public companies, and you're going to have to live with them . . .." Sometimes, even the other regulatory agencies are convenient targets to catch the blame. "Those crazy Regulators (read: agencies other than ours); What are they going to dream up next?" Some of them have merit. Others, unfortunately for the banker, are nothing more than regulatory barn door building as the violating cows roam the countryside. And it seems as though more are created when times are good and there are fewer real problems to vie for regulators' time.

Hot Buttons. There are new ones devised each calendar year. The inhabitants of the ivory tower send word to the front line grunts to enforce the latest rule de jour. Who can forget the myriad regulations and hardware updates required for the Y2K Bug? I should have gone into the gas-powered generator business. I never have figured out why examiners had to verify and enforce the requirement for "Branch Closing Policies". What if the bank didn't even have a branch? One of the latest hot buttons is very understandable. Federal regulators are vigorously enforcing the Patriot Act and BSA guidelines, with which most bankers are willing to comply given the ramifications of terrorist activities.

There is a hot button that has surfaced in the last couple of years, which has created the standard mountain of paperwork with limited benefits. Calculating an acceptable Allowance for Loan and Lease Losses (ALLL). And to make the issue more convoluted; enforcement from the various regulatory agencies is uneven. While some agencies are demanding compliance to the letter of the law, others are barely acknowledging its existence.

Financial Accounting Standards 114 and 5 have been on the books for some time now, but it wasn't until fairly recently that the guidelines were used in developing a joint agency policy for all banks. Evidently, the dictum for all banks was a result of public companies running afoul of the Securities Exchange Commission. Now, the question is what is an appropriate application for privately held banks that have historically had sufficient or "excess" reserves?

There are effective and reasonable guidelines in the policy statement. I know this opinion has endangered my credibility with some bankers, but there it is. What may be the single most important pronouncement in the policy is:

The amount of the ALLL should be based on management's current judgments about the credit quality of the loan portfolio.

Granted, this is not new information to the average banker, but it should be the fundamental STARTING point for satisfactory credit administration and eventually an adequate ALLL. If you don't assess the potential loss on each of your problem loans, why not? Loan committees or the Board certainly should be well versed in the bank's worst loans and are expected to assess their exposure regularly.

If, in the course of an examination, examiners find a number of weak loans that management has not previously identified, it raises questions regarding the Board's willingness to address growing problems and subsequently the adequacy of the ALLL. Regardless of the presence of rules or not, estimating the exposure in each problem loan and reserving for it is a prudent function for all banks.

The big question that can't be answered is - what is an adequate amount to maintain in the reserve for the rest of the portfolio? How much is enough? Or too much? Regardless of the regulatory agency, there are - hopefully - no individuals misguided enough to come out and say that a bank has too much in their reserve account.

The more rabid of the regulatory agencies spend the bulk of their time "fine tuning" the bank's approach to the FAS 5 component. They help management develop believable reasons to justify the extra $500M in the reserve to better comply with the directive. The Downturn in the National Economy, The Danger of Real Estate Values Dropping Dramatically, The Potential of Livestock Being Sold Out of Trust, The Risk of Loan Officer X Defrauding the Bank, The Concentration of Used Car Loans-Restaurant Loans-Airplane Loans-Beauty Shop Loans? and the list goes on.

But according to the joint agency decree, actual practice is not enough. The Board must develop a policy as well. I've seen regulators go back and forth (read: months of correspondence and paperwork) with bankers hammering out an acceptable ALLL Policy and the subsequent adequacy review process. I will go on record as an advocate of reasonable policies, but keep it real. Don't write a policy for the examiners. Develop a policy that works for you. Also, if your bank has $10 million in total assets, don't write the great American novel. And if you do "borrow" a policy from Sheshunoff or another bank, at least change "your bank's name here" to your bank's actual name. Whatever you decide to do, document it, support it, and stand by it. That will satisfy or scare off most examiners.

So you have your policy, and you've determined that the ALLL is sufficient for the bank's needs. Yet there's one small problem. Your ALLL has been criticized in the current or past examination for being inadequately funded. Do not lose heart, the situation can be rectified in relatively short order if the Board is willing to address it aggressively and promptly. If there remains a difference of opinion, refer to my comments in the previous paragraph (document it, support it ?).

Certainly, your bank is one of the many that maintain ample reserves, so life is good. The inquisition into the adequacy and proper structuring of your ALLL will only be temporary. Any comments in the Report questioning your compliance with Rule 49837 will eventually wane. Loan quality and an abundant reserve will win out in the end.

Just between you, me and the fence post, I'll tell you a little secret. Get your information from several sources. Consider FAS 114 and 5. Monitor historical loss data. Keep track of your peer banks and the percent of total loans devoted to reserves. Even give a nod to the formula brought down the mountain by Moses - 100% of Loss, 50% of Doubtful, 15% of Substandard and X% of all other loans. You will do yourself and the bank a favor by taking into account a wide array of approaches. Hot Button or not, examiners sleep well at night when the Board thoughtfully addresses ways to reduce risk, and acts on them.

Jeff Bagby is a Regional Examiner with the Oklahoma State Banking Department. He has spent 17 years in bank regulation which includes a wide spectrum of knowledge and experience. In the early part of his career, the banking industry in the central region of the United States endured its most devastating era since the FDIC was established bringing with it numerous bank closures. In addition to writing examination reports and working with bank management, Jeff teaches Loan Officer Seminars which is aimed at revealing to bank lenders how and what an examiner looks for when reviewing loans.

Jeff received a B.B.A. from the University of Oklahoma in 1985 and is a graduate of the Conn Graduate School of Community Banking.

First published on BankersOnline.com 05/01/03