Statement by Laurence H. Meyer, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services, U.S. House of Representatives, June 16, 1999 - Transcript

Federal Reserve Bulletin, August, 1999

I welcome this opportunity to discuss the Federal Reserve's views on recent developments relating to the allowance for loan losses.

As a supervisor of banking organizations, the primary focus of the Federal Reserve is on promoting a safe and sound financial system. Conservative allowance levels contribute to safety and soundness by ensuring that insured depository institutions maintain strong balance sheets and capital levels that reflect the collectibility of the loan portfolio. Accordingly, the Federal Reserve and the other banking agencies have long encouraged institutions to maintain strong loan-loss allowances. As a reminder of the importance of conservative allowance levels, we need look only to recent experiences in certain foreign countries and to the problems in the banking and thrift industries in the past decade.

In its role as a securities regulator, the Securities and Exchange Commission (SEC) focuses primarily on the transparency of financial statements and reported earnings to investors. The Federal Reserve also recognizes the importance of transparent financial statements and has been working to enhance transparency domestically and abroad. Improved transparency can enhance market discipline and thus reinforce supervisory efforts to promote sound risk management and contribute to a safe and sound financial system.

Indeed, banking organizations have long been expected to follow generally accepted accounting principles (GAAP) in their published financial statements and in regulatory financial statements filed with the banking agencies--an approach supported by Congress in the Federal Deposit Insurance Corporation (FDIC) Improvement Act of 1991.

BACKGROUND AND EFFORTS TO WORK TOGETHER WITH THE OTHER FEDERAL BANKING AGENCIES AND THE SEC

In the fall of 1998, the SEC announced an initiative to address earnings manipulation by registrants in a number of industries. After the announcement of this initiative, the SEC raised concerns regarding the loan-loss reserve practices of some banking organizations, requiring one banking organization to reduce its reserves by $100 million. The federal banking agencies were concerned about these actions from a safety and soundness standpoint. The agencies' involvement led to the issuance of a November 1998 interagency statement, which set forth a framework for the banking agencies and SEC to begin working together on loan-loss allowance issues.

Subsequent to the issuance of the November statement, further questions arose regarding bank loan-loss reserves, including concerns about the possibility that the SEC would take further actions against some banks that were perceived as having excessive reserve levels. In addition, around this time, the SEC issued letters to a number of banking organizations regarding their loan-loss allowance disclosure practices. Taken together, these developments generated additional uncertainty in the banking industry and may have created a perception that loan-loss allowances would have to be reduced.

In order to address any misunderstandings, the federal banking agencies and the SEC issued another joint letter on March 10, 1999, reiterating the agencies' agreement to work together and announcing a number of joint efforts. The joint letter announced new initiatives of the agencies and the accounting profession to develop enhanced guidance on loan-loss allowances over a one- to two-year period. In addition, the agencies stated that they would support and encourage the processes of the accounting standards setters as they seek to clarify key loan-loss allowance accounting issues. Most important, the letter indicated that the agencies will meet together periodically to discuss important matters that affect bank transparency and will focus on enhancing allowance practices going forward. The spirit of the March 10 joint letter was to put into place a process for resolving issues related to loan-loss allowances going forward, and permit the agencies to work together in this process to resolve allowance matters and avoid significant changes in methodology that would encourage a decline in allowances before this process had run its course.

The Federal Reserve Board has been pleased to host a number of the meetings announced in the March 10 letter between the banking agencies and the SEC to discuss important loan-loss reserve issues, and the other agencies have been active in supporting these discussions as well. The banking agencies and the SEC formed a new Joint Working Group, composed of senior accounting policy representatives of each of the agencies, to review sound practices used by institutions for documenting and supporting their loan-loss allowances. The agencies intend to issue parallel guidance in this important area in the next year.

The Joint Working Group is also developing enhanced disclosures related to the allowance for loan losses and the credit quality of institutions' portfolios. This effort is intended to improve the transparency of loan-loss allowance amounts and improve market discipline. A key aspect of these efforts will be obtaining input from the banking industry and the accounting profession on allowance issues.