Management of loan loss reserves by commercial bankers--part 1

Journal of Bank Cost & Management Accounting, The, 1996 by Joyce, William B

Management of Loan Loss Reserves by Commercial Bankers-Part 1* by William B. Joyce**

INTRODUCTION

It is hypothesized that loan loss reserves at banks are at least partially managed, or manipulated, in order for bank managers to maximize their cash bonus compensation. Three related bodies of literature will be examined to provide support for this hypothesis. The first section will provide the theoretical basis, informational implications and financial presentation of loan loss reserves. Then, a discussion of the loan analysis techniques and income tax considerations will be presented. This section will conclude with an illustrative example. The next section will review the managerial compensation research. The final section, the income management literature, will be used to integrate the accounting for reserves and compensation literatures, as well as providing the basis for the research question.

ACCOUNTING FOR LOAN LOSS RESERVES

"Management assesses lending risks, economic conditions and other relevant factors related to the quality of the Bank's loan portfolio in order to establish a prudent level for the allowance for possible loan losses. Results of examinations and appraisals of the loan portfolio by internal and independent reviewers and state and federal regulators are also considered by management in determining the amount of the allowance. The Bank contributes to its allowances for possible loan losses based upon its best estimates of the amount of potential loan losses, and ultimate losses may vary from such estimates. No assurance can be given that the Bank may not sustain loan losses in excess of the size of the allowance." Bank of San Francisco, Annual Report (1992), p 43.

The primary business of commercial banking is the collection and investment of depositors' funds. As part of this business, banks bear credit risk (that is the possibility that the borrower will fail to repay as promised). The two major assets in which banks invest depositors' funds are securities and loans. Credit losses on securities are minimal because the bulk of these holdings are government securities with little or no default risk. However, loans can have significant default risk.

Loan loss reserves represent the portion of loan principal not expected to be paid back; they are a deduction from total loans used to express a net realizable value. The reserve is maintained by a charge against operating expenses called the provision for loan losses. The financial presentation of the reserve, provision and supporting analysis will be provided later.

LOAN LOSS RESERVES THEORY

The federal banking regulators (the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Federal Reserve) require that all banks include in their financial statements an account called "Loan Loss Reserves" (also known as "Allowance for Loan Losses"). Loan loss reserves are also consistent with the Financial Accounting Standards Board's (FASB) generally accepted accounting principles (GAAP).

The bank's board of directors, creditors, regulators and investors would be misled if the bank's balance sheet displayed the amount of funds lent without an expected, although uncertain estimate of, future losses. The bank's assets would be overstated. The income-earnings potential of the bank and its capital also would be overstated, resulting in the bank looking stronger than it actually is. Most financial statement users would prefer the balance sheet to reflect as loans only that portion of loans that is expected to be collected, or net loans. However, it is difficult for bank managers to determine, before the fact, which loans will be repaid. A compromise used by banks is to estimate the amount of losses that are likely to result from all of the loans in the bank's portfolio and to call this estimate the allowance or reserve for loan losses. According to the American Institute of Certified Public Accounts (AICPA),

. . . the allowance for loan losses represents an amount that, in management's judgement, approximates the current amount of loans that will not be collected. [1994, p. 50].

Informational Value of Loan Loss Reserves

Depositors, investors and analysts are generally not privy to information about the riskiness of a bank's loans beyond that which is revealed by the amount of past-due and non-accrual loans (which banks are required to report). That is, bank managers have more information about the quality of the loan portfolio than outsiders. Data on the size of a bank's reserves and additions made to reserves are useful to outsiders; they provide additional information about the riskiness of the loan portfolio. The value of this information is demonstrated by Elliot, Hanna and Shaw (1991) who find a strong reaction of bank stock prices to unexpected news about changes in reserves. Similarly, Griffin and Wallach [1991] found that the market reacted unfavorably to the announcement that loans have been reclassified to a non-accrual basis.