Heed a Banking Champion's Words on Loan Loss Reserves

The banking industry suffered credit crises in the 1970s, 1980s, 1990s, and 2000s. An unavoidable conclusion is that its loan loss reserves were in all cases too small.

At the height of the great 21st century housing bubble in December, 2006, for example, with a flood of losses about to swamp them, American banks' aggregate loss reserves were merely a little over 1% of total loans.

Since in each decade, the reserves were too small, the pre-crisis reported profits were bigger than the profits really were. In other words, optimistic credit booms produce illusory profits built on insufficient loss reserves.

Illusory profits in turn produce management bonuses that are too big, dividend payout ratios that are bigger than they appear, and especially, stock buybacks which liquidate equity which will be needed later. How the banks of 2007-2009 would have loved to have back again the equity they dissipated with high priced stock buybacks in the preceding boom! Instead they got Tarp equity.

All this shows what a joke are the Security and Exchange Commission's attempts to hold down loan loss reserves on the theory that it is preventing "cookie jar accounting." In fact the SEC has consistently promoted illusory accounting for banks, whose profits can be understood only over credit cycles. The SEC is thus one of the culpable parties in credit bubbles and busts.

How big should banks' loan loss reserves be? Let us consider the advice of an old-fashioned real banker, prominent and very successful in his day, George Champion. Champion was the Chairman of the Chase Manhattan Bank 1961-69, when it was a top bank in the world (three decades before the mergers which resulted in the JPMorgan-Chase Bank of today). His reflections are recorded in James Grant's sardonic and instructive book "Money of the Mind."

Champion's advice: "I have long said that what they ought to do is to increase the reserve for bad debts until they get to a point of having at least 5% of total loans. This would not be out of line in view of the enormous losses that had to be written off in the last few years."

Champion was speaking in 1978, so by the write-offs of "the last few years," he was describing the enormous credit losses of the 1970s. But the same can be said of the credit losses of the 1980s, 1990s and needless of say, of the 2000s. "About every ten years, we have the biggest crisis in 50 years," as Paul Volcker rightly said, but somehow this truth does not penetrate our ideas of the size of the loss reserves that are really required.

As Champion reflected 34 years ago, describing a more prudent day a decade before that: "We tried to put out the most conservative statement possible. We did everything we could to set up reserves wherever possible in terms of questionable loans. We knew we would come into periods when we needed to call on reserves and the statutory limitation on reserves was so bad that there was no way to set up as much as we felt it was necessary to have, prudent to have." How true it is that these periods keep arriving.

So, said Champion: "Take a quarter of 1% each year and add to the reserve for bad debts until you get 5%." This will help achieve the main point: "Don’t get in a position where you are going to have to rely on the government to bail you out." And: "Remain strong… particularly in a period such as we are facing” (1978, but also true in 1988, 1998, and 2008 &mdash ;in fact, in every period).

Indeed, Champion thought: "Banking should be in such an unquestionably strong financial position that they should be able to tell the government what they are going to do and not have it vice-versa. Banks should decide the proper ratios that are right in terms of loans to capital, total risk assets to capital" — and naturally, loan loss reserves to loans. We have strayed a long way from Champion's banking philosophy of prudence and independence.

George Champion died in 1997 at the age of 93. One can imagine his gazing down from banking Valhalla frowning with displeasure at the imprudent financial adventures since then, which have certainly confirmed his views. What would he be advising as we struggle to recover from the great 21^st century financial crisis? Surely: Get those loss reserves up to 5% of loans!

Will we listen this time? 

Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.