Office of the Comptroller of the Currency
Board of Governors of the Federal Reserve System
Federal Deposit Insurance Corporation
Office of Thrift Supervision
July 12, 2000
Mr. Martin F. Baumann
Chairman
AcSEC Allowance for Loan Losses Task Force
American Institute of Certified Public Accountants
1455 Pennsylvania Avenue, NW
Washington DC 20004-1081
Dear Mr. Baumann:
We appreciate the efforts of the Accounting Standards Executive Committee's (AcSEC) Allowance for Loan Losses Task Force (Task Force) to provide
- The Task Force's guidance appears to be directed at ensuring that loan loss estimates are not overstated. In practice, the guidance is likely to produce loan loss allowances that are understated, particularly as the condition of borrowers weakens in periods immediately preceding an economic downturn. Loss recognition may be delayed if institutions believe the Task Force's guidance requires greater certainty of a loss event that is prudent. Therefore, we urge greater balance in your guidance to ensure that institutions establish prudent, conservative, but not excessive loan loss allowances.
- The use of credit risk downgrades and past due status as the only criteria for establishing allowances for pools of loans should be reconsidered. While downgrades and delinquency status are important indicators, they should not be the sole determinants of loss recognition on loans. We note that it is not practical for institutions to review the risk rating of each credit-graded loan as frequently as loan loss allowances must be estimated for financial reporting purposes. As a result, losses can occur in some of the better-rated loans and not be identified until a subsequent period when the loans are reviewed. Therefore, when the ratings are used to determine the allowance, estimated losses on all loans in the various rating categories (pass, substandard, and doubtful) should be considered, not just losses on loans that have been downgraded below investment quality. In addition, since delinquencies do not necessarily coincide with the occurrence of loss events, they are often not a timely indicator of incurred loss. Because of the limitations in these two indicators of credit loss, institutions should continue to be permitted to also rely on such criteria as historical experience migration analysis, and current economic factors to measure losses inherent in their loan portfolios.
- The draft guidance requires institutions to adopt a credit risk grading scheme that includes grades that correspond to those used by bond rating agencies. While we understand the need to ensure that institutions do not use their own rating grades to alter the intent of the guidance, we believe any attempt to mandate a specific grading system will be burdensome and impractical, particularly for the large number of smaller, less sophisticated institutions. Rather, to the extent ratings are used to determine allowance amounts, the credit risk grading scheme in your draft should be presented only as an example.
The draft guidance should build upon, and not detract from, interagency guidance jointly issued by the SEC and the federal banking agencies that is consistent with and included in generally accepted accounting principles. This guidance, which is included in the joint interagency statement dated July 12, 1999, and in FASB EITF Topic D-80, permits an unallocated allowance when it reflects an estimate of probable losses, determined in accordance with GAAP, and a margin for imprecision for the highly judgmental aspects of determining the allowance that takes into account all available information existing as of the balance sheet date.
Finally, we are concerned that the Task Force is moving in a different direction than the FASB, which has a project underway to move more toward a fair value framework for financial instruments. We believe that for many institutions, their current use of a risk rating model and expected loss approach as part of the process for determining loan loss allowances is within the framework of the FASB's goals.
We would like to meet with you to discuss the draft guidance and related supervisory issues. Our Chief Accountants will be contacting you to arrange for this meeting.
