How to Check if Your Bank Is Adequately Reserved

A recent American Banker story on loan-loss reserves ("Why Better Loan-Loss Coverage Masks a Hidden Danger," June 5) asks many important questions but provides few useful answers.

Loan reserving is one of the most important decisions in banking. Yet there is no accounting, regulatory or industry numerical guideline for "adequate" levels of the allowance for loan and lease losses. The article did not provide any guidelines and neither will the Financial Accounting Standards Board's forthcoming, more forward-looking reserving model.

The lack of reserve adequacy guidelines is good and bad news for bankers. On the positive side, it allows them subjectivity – some would argue way too much – in setting the appropriate level of reserves. On the negative side, it subjects them to criticism from conflicting views of regulators, outside auditors, analysts, shareholders, and others.

There is little room for subjectivity with capital adequacy, and it has long been my view that there should be similar standards for loan reserving.

An ALLL adequacy standard requires a qualitative and a quantitative component, namely the most relevant benchmark ratio and then appropriate adequacy levels for it.

I believe the most relevant ALLL benchmark is the reserve coverage ratio, defined by the FDIC as ALLL over noncurrent loans. The American Banker article was right to focus on this ratio, but fell well short of addressing the most important question: what is an appropriate adequacy level?

The article quoted ex-regulators, and it is not surprising they would argue that higher RCR levels are a "positive sign"; that banks "should continue to be aggressive in their reserving"; and that accountants' suggestions to reduce reserves are "ridiculous."

Moreover, they did not offer any suggestions as to an appropriate RCR level. "It's difficult to draw strong conclusions about whether or not banks have a high enough coverage ratio," one regulatory veteran said. "Whatever it is, it is never high enough whenever we encounter serious financial difficulties." With all due respect to these experienced ex-regulators, such general comments are not very helpful to bankers.

Realizing every banker, accountant, and regulator may disagree, I have developed my own RCR adequacy guidelines over the last few decades. They are based on my opinion that a bank with a 100% RCR is well reserved, since it simply means a dollar allowance for every dollar of noncurrent loans. I further believe that a bank with an RCR in the 75% to 99% range is adequately reserved and anything below 75% is inadequate or under-reserved, but to different degrees:

The Federal Deposit Insurance Corp. reports that the average RCR as of March 31, was 68%, up from 64% on March 2011 and on June 30, 2009, but down considerably from 120% on June 30, 2007. By comparison, the median RCR for the more than 6,700 banks as of March 31, 2014 was 139%, but this was again much lower than the comparable midyear 2007 median of 224%. These medians are much higher than the comparable averages because of the large number of small banks with high RCRs.

Based on my ALLL adequacy guidelines, 28% of all banks were under-reserved as of March 31, 2014 compared to 19% in mid-2007, before the crisis began. The current 28%, however, is a major improvement from the 47% and 45% of under-reserved levels as of June 2009 and March 2011, respectively, during the crisis.

While it is certainly good news that the portion of under-reserved banks has decreased from nearly one half to just above one quarter, there is still reason for concern. A large number of the nearly 1,900 under-reserved banks reporting a small profit would not be profitable if they were adequately reserved. An even greater concern, however, are the more than 200 banks that are critically under-reserved as of March 31.

Banks that are criticized for being under-reserved under these guidelines typically respond that the analysis ignores important mitigating factors such as a recent trend of reduced noncurrent loans; their improving quality; strong capital; good earnings; an experienced workout staff; FDIC loss-sharing arrangements; aggressive nonaccrual writedowns and chargeoffs; favorable recovery experience; a well-diversified loan portfolio; a strong local economy; or a niche business strategy (for example, a trust bank with few loans). There are, of course, banks in the opposite situation where one or more aggravating factors would justify an even higher reserve coverage ratio.

The purpose of these or any guidelines, however, is to attempt to simplify a complex situation without introducing numerous such mitigating or aggravating factors that make an objective benchmark subjective and inconsistent.

Bottom line: these ALLL adequacy guidelines should prove more helpful to bankers than simply saying "higher is better."

Kenneth H. Thomas, an independent bank consultant and economist, was a lecturer in finance at the University of Pennsylvania's Wharton School for over 40 years.