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The Role of Loan Loss Reserves
in Measuring the
Capital Adequacy of Commercial Banks
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Board of Governors of the Federal Reserve System
THE ROLE OF LOAN LOSS RESERVES IN MEASURING THE
CAPITAL ADEQUACY OF COMMERCIAL BANKS
Section 3604 of the Omnibus Trade and Competitiveness Act
enacted by Congress in December, 1988, requires the Federal
Reserve Board to submit a report on the issues raised by
including loan loss reserves in the primary capital of
commercial banks.
The Act states that the report should address
the treatment of loan loss reserves and the composition of
primary capital of banks in other industrialized countries and
should also include an analysis as to whether loan loss reserves
should continue to count as primary capital for regulatory
purposes.
This report presents the Federal Reserve Board's
analyses and recommendations.
summary
Loan loss reserves have traditionally been included in official
supervisory measures of bank capital because they are available
to absorb identified losses.
They are part of primary capital,
which has been the official standard since 1981, and most
recently have been included, subject to certain limitations, as
part of the internationally agreed upon risk-based capital
standard.
In earlier decades, authorities also considered these
reserves to be part of supervisory capital, although no official
standard existed.
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1
Previously, though, these reserves took on a somewhat
different character.
They were generally much smaller relative
to loans and equity, and they were clearly of a more general
nature.
Rarely in the past had banks established "special"
reserves tied to particular developments, as they did in 1987
for loans to heavily indebted countries.
Moreover, any such
reserves in the past were not as large as the substantial
special reserves that the largest U.S. banks have today.
The
level of international competition among banks was also much
less in prior years.
National authorities could determine
supervisory standards that met their needs with little
consideration to practices abroad.
By almost any measure, the special reserves created in
1987 had a major impact on the way loan loss reserves were
viewed in evaluating bank capital.
They also compounded the
growing problems of comparing capital measures of U.S. and
foreign banks and maintaining an equitable basis for
competition.
Authorities from around the world began to focus
on these issues and, with the adoption of the international
"Basle Accord," developed a new standard of capital
adequacy--one tailored to the risk profile of the bank and that
could apply similarly to all.
As a participant in the development of this Accord,
the Federal Reserve Board supports the inclusion of loan loss
reserves as part of capital, as prescribed by the Accord.
To
qualify as capital, reserves must not relate to specific assets
and must not reflect a reduction in the valuation of particular
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assets.
In addition, the role played by reserves in capital
should do nothing to undermine the maintenance of an adequate
base of core or equity capital.
The treatment of loan loss reserves was discussed at
length during the recent international negotiations on the
risk-based standard.
Participants recognized that it is not
always possible to distinguish clearly between general loan loss
reserves which are genuinely free to absorb unidentified losses
and those reserves that, in reality, are earmarked against
assets already identified as impaired.
In addition, they wanted
to ensure that banks held adequate amounts of "core" capital and
that the banks not expand their activities on the basis of
reserves that were effectively devoted to possible charge-offs
of existing, though unrecognized, losses.
In negotiating the Basle Accord, the participants
decided to continue reviewing the treatment of loan loss
reserves as capital with the intent of developing more
consistent and definitive guidelines on the types of reserves
eligible for inclusion in capital by the end of 1992.
However,
in the event further agreement is not reached, the amount of
loan loss reserves that qualify as capital would be phased down
so that, at the end of 1992, such items would constitute no more
than 1.25 percent (or exceptionally and temporarily up to 2.0
percentage points) of risk weighted assets.
Such reserves would
also be considered as a secondary element of regulatory capital.
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structure of the report
This report is divided into several parts.
The first part
provides a background for evaluating the role of loan loss
reserves as capital by describing the basic functions of capital
and the evolution and role of reserves.
The second part
demonstrates the practical effects of the factors influencing
the level of reserves by showing how the relation between
reserves and other performance measures of U.S. banks has
changed.
The third part of the report reviews the treatment of
loan loss reserves and the composition of primary capital in
selected foreign industrialized countries.
The differences
highlighted illustrate the increasing need for a more consistent
international capital standard in a market where national
boundaries are becoming less important.
Finally, the recently
adopted risk based capital standard, which should address many
of these problems, is the subject of the fourth part.
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PART I: THE CONCEPTUAL ROLE OF BANK CAPITAL
AND LOSS RESERVES
Banks and other financial institutions build reserves for loan
'
losses because such losses are a normal operating expense
associated with the business of lending.
In the long run, a
bank can adjust its pricing policies to cover these and other
operating costs and provide an adequate return to its owners,
but it must first withstand shocks arising from short-run
events.
Banks have essentially three "lines of defense" to
withstand loan losses:
and (3) equity capital.
(1) current earnings,
(2) loss reserves,
In both theory and practice, these
elements are closely linked.
A bank's loan loss provision is an
operating expense that reduces the earnings it would otherwise
report and is the method by which loan loss reserves are
increased.
All loan charge-offs, in turn, are charged against
and reduce the reserve and do not directly affect either equity,
operating expenses, or net income.
Finally, if a bank needs to
make such large provisions that it incurs an operating loss, its
equity capital declines.
overview of bank capital
This section provides background information on the role of bank
capital, including a definition of capital generic to all firms
and the definition of capital, as applied to banks.
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Definition of capital.
Traditionally defined, capital
represents the owners' interest in a business and may take two
principal forms: equity capital and, under certain conditions,
subordinated debt.
Equity is the purest form and represents the
owner's historical investment in a business.
Mechanically, it
is the difference between the reported assets and liabilities of
an organization.
(1)
Equity consists of two parts:
funds contributed to the organization externally
through investments by owners in the form of either
common or preferred stock--including contributions in
excess of stated par values, and
(2)
previous earnings that have been retained by the
organization and not distributed to owners through
dividends.
For this purpose, retained earnings would
also include any capital reserves, which are
effectively segregated portions of retained earnings
(or other capital), that may be established to meet
various contingent obligations.
Subordinated debt may also represent capital if its specific
terms require that the debt be converted into equity or that it
otherwise absorb losses under certain circumstances.
Since 1981, the U.S. bank regulatory agencies have
used a measure of bank capital that recognizes these and other
forms of capital.
"Primary" capital consists of common and
perpetual preferred stock,
loan loss reserves, minority
interests in consolidated subsidiaries, debt whose terms require
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that it eventually be converted into equity funds ("mandatory
convertible debt"), and perpetual debt (i.e., debt that has no
maturity date and that automatically converts into equity if
losses reach a certain level).
''Total" capital is primary
capital, plus limited-life preferred stock and other types of
subordinated debt.
The current U.S. regulatory minimum standard for
capital adequacy requires commercial banks and bank holding
companies to maintain primary capital ratios of 5.5 percent of
assets and total capital ratios of 6.0 percent.
This approach
ensures that equity and other permanent capital components
dominate the measure, while recognizing the potential benefits
of subordinated debt and its economic advantage to banking
organizations.
Functions of capital.
The essential functions of capital in
banks differ somewhat from the generic functions that apply to
capital for nonbanking firms.
These differences evolve from the
support banks have traditionally received from governments and,
in the United States, also from the nature of the deposit
insurance system.
A.
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Generic functions:
(1)
Capital absorbs losses.
This is its principal role.
(2)
Capital promotes economic efficiency, encourages
greater self-discipline by management, and helps to
protect the customers' interests.
7
By having their own
funds at risk, investors and managers are discouraged
from taking excessive risks.
(3)
Capital helps to allocate economic resources to areas
of greatest need.
Equity funds provide the basis for
redistributing still other resources to areas where
they can be better employed based upon market demands.
B.
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Functions specific to banking:
(1)
Capital serves to promote public confidence.
Uninsured depositors are unsecured creditors and place
their funds in banks with the expectation that both
the principal and interest are safe.
An adequately
capitalized banking system helps to maintain public
confidence in both private and public institutions.
Such confidence is particularly critical to the
viability of banks and other financial institutions
that depend heavily on short-term borrowed funds.
(2)
Capital, combined with formal or informal leverage
limits, restricts excessive growth.
The level of
government protection historically given to banks, and
the specific nature of the U.S. deposit insurance
program, tend to reduce market discipline on the
activities of banks.
Insured depositors, whose funds
are protected, may become indifferent about where and
how their funds are used.
This indifference can fuel
growth of inefficient organizations that do not
efficiently employ the funds and can place the
8
institutions and banking system at greater risk.
Meaningful leverage limits force management to
demonstrate that it can adequately employ new
resources in order to attract investors and obtain
equity funds to facilitate further growth.
(3)
Capital provides management and government authorities
additional time to take corrective action.
Without an
adequate loss-absorbing cushion, adverse events can
make an institution insolvent with little warning.
The use of loan loss reserves
Reserves are used because banks, through experience, are able to
predict with some accuracy the size of expected losses and
because the "matching principle" under Generally Accepted
Accounting Principles (GAAP) holds that expenses be matched
with, or recorded in the same period as, the revenues that they
helped to generate.
Under this principle, estimated credit
losses should be recorded for loans because they are a "cost"
associated with the interest income generated by those loans.
Periodic additions to a loan loss reserve provide the funds to
absorb the losses when they finally occur.
Different "types" of reserves.
There are essentially two types
of loan loss reserves: "General" reserves are available to
absorb losses anywhere in the portfolio, and do not reflect a
reduction in the valuation of particular assets.
"Specific"
reserves, on the other hand, are identified with specific assets
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that show clear indications of loss; they effectively represent
charge-offs and are not recognized as capital by most regulatory
bodies.
Recognizing the difference between these two concepts
is critical to any discussion concerning the inclusion of loan
loss reserves in bank regulatory capital.
Influencing factors.
The size and role of general loan loss
reserves have been affected principally by three factors:
the level of losses a bank expects to incur,
(1)
(2) the amount of
reserves (or loss "provisions") it may deduct for tax purposes,
and (3) regulatory and accounting policies.
For decades, U.S.
tax laws encouraged banks to maintain reserves larger than their
historical losses.
More recently, however, both the tax laws
and the loss experience of the banking industry have changed and
have made accounting and regulatory policies more significant in
determining the level of reserves.
Each of these factors is
discussed below.
(A)
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Level of expected loan losses.
Assessing the quality of a
bank's assets and identifying likely or actual losses is an
on-going activity at most banks.
At least quarterly the
results of that review are revealed in publicly disclosed
statements.
When evaluating the bank's losses, management
collects input from lending, accounting, and credit
officers, economists, and other sources to reach judgments
about the size of known losses and the likelihood of
others.
Known losses are charged-off against the
10
established reserve, and the assets are removed from the
loan portfolio.
Losses that are not specifically known are
the basis for establishing on-going reserves.
Banks may use a variety of procedures to estimate
future losses on their existing loans.
Commonly these
procedures involve dividing the loan portfolio and
off-balance sheet exposures into several categories:
(1)
pools of specific types of loans with common
characteristics.
Loans in this category generally
exist in large numbers and tend to have relatively
steady and predictable rates of loss, such as consumer
loans for credit cards, automobile financing, and even
home mortgages.
Some of these loans will be
completely, or almost entirely lost, while others will
remain sound.
Losses from this category of loans can
often be actuarially based with reasonable accuracy.
(2)
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loans with similar characteristics and whose borrowers
appear to be sound.
These loans may include all
commercial and industrial loans not placed elsewhere,
or loans to companies in specific economic sectors.
Collectively, loans to these borrowers share some
common elements of risk, but they are generally much
fewer in number than those in the first category, and
their expected rate of loss is usually more dependent
upon specific economic factors.
11
{3)
loans that demonstrate clear weaknesses.
This
category typically includes commercial loans, rather
than consumer loans, and would generally include all
loans "classified" or criticized either by internal
auditors or bank examiners.
Management often reviews
these loans individually to determine both the
likelihood and size of the possible loss.
Although
these loans are likely to experience a higher rate of
loss than those in the other categories, sufficient
uncertainty remains about the possibility or timing of
loss on individual assets that no specific charge-off
should be made.
Procedurally, all additions to, or reductions from,
the reserve are made through charges or credits to a
"provision for loan and lease losses" account on the income
statement.
Technically, then, actual loan losses {charge-
offs) are not part of an institution's current expenses.
Rather, they are deducted from an existing loan loss
reserve that is maintained by a periodic loan loss
provision, which is a current operating expense.
Recent
research indicates that the relation between current
provisions and charge-offs is generally strong. 1
1
S. Wayne Passmore and Betsy B. White, "The Effect of Loan
Losses on Bank Profitability," Recent Trends In Commercial Bank
Profitability, a staff study of the Federal Reserve Bank of New
York, Chapter 8, pp. 141-157.
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(B)
Tax laws.
During the period 1921 to 1965, banks were able
to deduct all increases to their loan loss reserves as
current expenses for tax purposes.
Consequently, banks
were encouraged by tax policy to maintain reserves at
maximum levels.
In 1965, however, the IRS issued Revenue
Ruling 65-92 and excluded loss provisions when the
allowance for loan and lease losses reached 2.4 percent of
eligible outstanding loans, a rate still larger than the
historical loss experience of most banks.
2
Several years later, with passage of the Tax Reform
Act of 1969, Congress revised those guidelines with the
intent to tie the banks' tax-deductions closer to their
actual needs.
It did so by prescribing two methods for
calculating tax-deductible amounts: the "percentage
method", and the "experience method".
The percentage
method allowed banks to deduct provisions that were
necessary to maintain a loan loss reserve at a designated
percentage of loans; it also specified that the percent
allowed should gradually decline.
The experience method
allowed deductions based on the amount of actual losses.
By the early 1970s, the reserve ratio for the
percentage method that was relevant for tax purposes had
declined from 2.4 percent of loans to 1.8 percent.
The
ratio continued to decrease through scheduled reductions
2 Board of Governors of the Federal Reserve System,
Commercial Bank Examination Manual, Section 219.1, page 1.
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until reaching 0.6 percent just prior to the Tax Reform Act
of 1986.
That Act, which is the most recent legislation
pertaining to this issue, eliminated the deductibility of
loan loss provisions completely and permits banks to deduct
only the amount of loans actually charged-off.
(C)
Accounting procedures.
Generally Accepted Accounting
Principles (GAAP) require banks to maintain an adequate
allowance for loan and lease losses.
The Statement of
Financial Accounting Standards (SFAS) No. 5, Accounting for
Contingencies, provides specific standards for the
accounting and reporting of possible losses by requiring
institutions to accrue estimated losses if both of the
following conditions exist:
1.
Information available before the financial statements
are issued indicates that it is probable that an asset
has been impaired or a liability has been incurred by
the date of the financial statements.
2.
The amount of the loss can be reasonably estimated.
The 1983 Industry Audit Guide, Audits for Banks, provides
additional guidance on the application of SFAS No. 5 to
banking institutions:
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A bank should maintain a reasonable allowance for loan
losses applicable to all categories of loans through
periodic charges to operating expenses. The amount of
the provision can be considered reasonable when the
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allowance for loan losses, including the current
provision, is considered by management to be adequate
to cover estimated losses inherent in the loan
portfolio. In other words, the propriety of the
accounting treatment should be judged according to the
adequacy of the allowance determined on a consistent
basis, no the provision charged to operating
expenses.
1
The Bank Audit Guide recommends that CPAs review several
factors when they assess the adequacy of a bank's loan loss
reserve:
(1)
the loss experience_with each major type of loan;
(2)
the structure of the loan portfolio;
(3)
the nature of any changes in lending policies and
credit review procedures; and
(4)
(D)
current economic conditions and trends.
Regulatory standards.
Bank regulators began in 1969 to
require banks·to charge a minimum provision for credit
losses against current income, regardless of the level of
existing reserves.
The procedures required by the
regulators emphasized historical charge-off rates and
generally produced an amount smaller than the maximum
expense allowed for tax purposes.
As a result, many banks
used the amount that was deductible for tax purposes for
financial statement purposes, as well; this conveniently
3
Audits of Banks, prepared by the Banking Committee,
(AICPA, 1983), pp. 61-62.
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solved the problem of separately determining the
appropriate level of reserves.
Banks tended to maintain
the maximum allowable IRS reserve and to assume that their
loan loss provisions were adequate if they exceeded the
regulatory minimum.
Loan loss reserves based on tax laws, however, do not
necessarily consider the panoply of economic and financial
factors required to adequately assess potential loan and
lease losses.
Moreover, in an environment of declining
credit quality, banks could be discouraged from increasing
their reserves, since any additions beyond those allowed
for tax purposes would be made with after-tax funds.
In view of these considerations, the banking agencies
changed their policies in 1975.
New guidelines were
developed that gave bank managers greater flexibility, but
that required them to document their rationale and to
maintain an adequate level of reserves.
Supervision policies, consistent with GAAP, now
require bank managements to maintain an "adequate"
allowance for loan and lease losses, and to evaluate the
adequacy of the allowance at least quarterly.
These
evaluations and the supporting documentation are subject to
examiner review.
Bank regulators have consistently
emphasized that bank management should critically and
frequently reassess its loan loss reserve and not rely
merely on a mechanical process or formula.
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PART II: A REVIEW OF THE DATA
U.S. banking supervisors have historically included loan loss
reserves in the definition of capital for assessing capital
adequacy--informally until 1981, and formally, thereafter.
That
approach was based on the view that a bank's reserves were
generally available to absorb losses throughout the loan
portfolio.
In June 1987, however, many U.S. banks established
special reserves typically equal to about one-quarter of their
exposure to heavily indebted countries.
Subsequently, some
banks charged-off, sold, or otherwise removed foreign loans from
their assets, while others have not.
These special reserves and
the diverse approach banks have taken toward resolving their
asset quality problems have changed the generally stable
relation between reserves and other measures of bank performance
and have also complicated the analysis qf bank capital.
Banks that reduced their foreign exposure have
depleted much of the special reserves that they could otherwise
count as capital under the primary capital measure but have also
improved the general quality of their assets.
In contrast,
banks that have not materially reduced their exposure continue
to report the reserves and, consequently, higher primary capital
ratios.
This effect has focused attention on the broader
question of whether loan loss reserves are fully general in
nature, or whether some portion of them reflect specific
valuation adjustments to particular assets.
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A review of several ratios will help to identify the
traditional level of reserves and the manner in which the level
has recently changed:
(1)
reserves as a percent of total loans.
This ratio reveals
management's view of the volume of expected losses inherent
in the existing portfolio.
Barring a major shift in the
nature of a bank's business that fundamentally changes its
level of risk, this ratio should be steady.
It should rise
as expected losses increase, but should then decline, as
losses are charged to reserves.
(2)
reserves as a percent of equity.
This ratio shows the
relationship of funds available for expected (though
unidentified) losses to funds available for unexpected
events.
An historically low ratio could mean, among other
things, that reserves are inadequate or that credit quality
is good; an historically high one could mean (a) that
reserves are too large (b) that the risk of the basic
business has increased, or (c) that the reserves have some
characteristics that are specific, not general, in nature.
(3)
nonperforming assets to total loans.
the quality of the loan portfolio.
This ratio measures
As the ratio increases
future losses should grow.
No single ratio reveals the full nature of the reserves or the
significance of any change.
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Examined together, however, the
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effect of the special reserves on the primary capital measures
of the largest banks becomes clearer.
(1)
From 1976 through 1986, all U.S. banks generally maintained
reserves equal to about 1.0 percent to 1.5 percent of loans
and around 10 percent to 15 percent of equity (Charts 1
and 2).
(2)
During 1987, reserves of the 25 largest banks rose from 1.8
percent of loans to more than 4.5 percent and from 22
percent of equity to more than 65 percent.
In sharp
contrast, the reserves of all other banks (those without
large foreign exposure and reserves) rose only moderately
by these measures during that time.
(Detailed figures are
provided in Appendix A.)
(3)
Nonperforming assets of all banks were also relatively
stable during 1982 through 1986 at around 2.5 percent to
3.0 percent of loans (Chart 3). 4 Since then, the ratio of
the 25 largest banks has climbed to 5.7 percent in 1987 and
then dropped to about 4.8 percent at the end of 1988.
This
level, again, contrasts with the asset quality ratio of the
smaller institutions.
4 Data on nonperforming assets were first reported in 1982.
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CHART 1
LOAN LOSS RESERVES/
TOTAL LOANS
Percentage
6
25 LARGEST U.S. COMMERCIAL BANKS
ALL U.S. COMMERCIAL BANKS
5
OTHER U.S. COMMERCIAL BANKS
---
4
3
,,,,. ---
2
-1
76
77
78
79
80
81
YEAR
82
83
84
85
86
87
88
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CHART 2
LOAN LOSS RESERVES/
TOTAL EQUITY
Percentage
70
25 LARGEST U.S. COMMERCIAL BANKS
ALL U.S. COMMERCIAL BANKS
60
---
OTHER U.S. COMMERCIAL BANKS
50
40
30
--- -
--------- - --- ---
20
10
0
76
77
78
79
80
81
YEAR
82
83
84
85
86
87
88
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•
CHART J
·NON PERFORMING ASSETS/
TOTAL LOANS
Percentage
7
25 LARGEST U.S. COMMERCIAL BANKS
ALL U.S. COMMERCIAL BANKS
6
---
OTHER U.S. COMMERCIAL BANKS
5
4
---- ---- ---- --- --- .......
--------
3
2
1
0
82
83
85
84
YEAR
86
87
88
If asset quality had improved for these largest companies,
one could argue that the increased reserves tend to be general
in nature.
However, in view of the apparent decline in asset
quality, one has reason to question whether certain components
of the reserve have characteristics that are specific, rather
than general.
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PART III: RESERVES AND PRIMARY CAPITAL ABROAD
Banking systems around the world operate under a broad
range of accounting and operating practices, laws, and
regulations.
These differences result from an array of factors,
ranging from the roles banks have performed in the economic
development of their countries to the variety of attitudes about
the information banks should (or may) publicly disclose.
These
differences have also made comparing and analyzing banks from
different countries a complex task.
When evaluating the capital adequacy of banking
organizations, one should focus on the total capacity of an
organization to absorb losses and on the amount of losses it
should reasonably expect.
In this regard, both equity capital
and reserves are available to absorb losses.
Publicly available data help to illustrate the broad
range of capital ratios and reserve information currently
reported by major banks throughout the world (Chart 4) but
reflect problems of comparability, as noted above.
The ratios
shown in the chart represent weighted average ratios reported by
selected major banks.
Although data for only selected banks
from each country were used, those institutions typically
accounted for a significant share of the banking assets in their
home countries.
The U.S. figures represent the average ratios
for the 25 largest U.S. banking organizations, which
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Chart 4
Equity and Loan Loss Reserves as a Percent of Assets,
Major Banks in Selected Countries
Percent
10.00
[ffi
Loan loss reserves/Total assets
■ Total equity/Total assets
8.00
6.56
6.00
4.00
2.00
0.00
l
Canada Germany
Japan
Neth.
Switz.
U.K.
France
U.S.
These figures are based upon publicly-reported numbers and do not reflect certain nondisclosed reserves or asset
revaluation reserves that may be included in regulatory capital in some countries. For some countries figures are as
of 1987; for others they are as of 1988.
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collectively represent 50 percent of the assets of all large
.
.
5
U.S. b ank ho ld ing companies.
These figures indicate that "typical" ratios of
reported equity relative to assets for the representative
foreign banks range from 2.4 percent {Japan) to 6.3 percent
(United Kingdom).
Adding available information on reserves, the
ratios range from 2.9 percent {Japan) to 8.1 percent {United
Kingdom).
By comparison, the average equity to assets ratio for
the 25 largest U.S. banking organizations is 5.4 percent and the
ratio after adding reserves is 7.5 percent.
These charts highlight the point that reserves are
treated differently among countries.
For example, banks from
Switzerland, the Netherlands, and Germany do not disclose their
loan loss reserves, while the U.S. and Japanese banks do.
However, the financial statements of Japanese banks do not
reflect the current market value of large holdings of equity
securities, which are carried for financial reporting purposes
at historical costs and are considered as regulatory capital.
more complete discussion of the tax and regulatory treatment of
loan loss reserves abroad is provided in Appendix B.
All of
these factors accentuate the differences among bank capital
definitions and standards.
5
At the end of 1988, these 25 largest companies had total
assets of $1,350 billion, (~o~pared with $2,700 billion for all
U.S. bank holding companies that had assets exceeding $150
million.
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A
This general lack of international consistency, the
growing globalization of banking markets, and the need to
strengthen the soundness and stability of the international
banking system, were among the major factors leading to the
adoption of a consistent international standard of capital
adequacy.
That risk-based capital standard, endorsed by the
central bank governors from the Group of Ten countries, is known
as the Basle Accord.
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PART IV.
THE RISK-BASED CAPITAL STANDARD.
The issue of the treatment of loan loss reserves was a
particularly complicating factor to authorities from around the
world that negotiated the recently adopted risk-based capital
standard.
Most participants recognized the loss-absorbing
nature of general loan loss reserves, but wanted to distinguish
between general and specific reserves.
Where provisions have
been created against identified losses or in connection with a
demonstrable deterioration in the value of particular assets,
they are not freely available to meet unidentified losses which
may subsequently arise and do not possess an essential
characteristic of capital.
Such specific or earmarked
provisions should, therefore, not be included in the capital
base.
The solution reached was to divide capital into two
groups: a core or "Tier 1" segment consisting of shareholders'
equity and a second supplementary or "Tier 2" segment for more
restricted types of "capital."
Loan loss reserves and other
"non-core" items were placed in the second group.
This
distinction reflects the predominant role accorded to common
stockholders' equity due, in part, to the fact that it provides
maximum flexibility to absorb losses.
Although, the risk-based capital standard recognizes
loan loss reserves, it does so with limits:
first, only
general, not clearly specific, allowances are considered to be a
component of capital.
The "allocated transfer risk reserve" of
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U.S. banks and specific reserves of other countries are excluded
6
from the definition of capital.
Secondly, loan loss reserves
that may reflect lower valuations of assets are limited (under a
phase-in period) in view of the potential uncertainty over
whether such reserves are freely available to absorb losses
anywhere in the portfolio.
Recognizing the confusion surrounding the proper
treatment of reserves, the parties to the Basle Accord agreed to
develop proposals by the end of 1990 to ensure international
consistency in the definition of loan loan loss reserves
eligible as capital.
In the event that agreement is not
reached, permissible allowances for loan and lease losses will
be reduced to 1.25 percent of risk weighted assets by the end of
1992. 7 Reserves beyond that limit will not be counted as part
of bank capital.
This approach seems to strike a reasonable balance in
the treatment of loan loss reserves.
It recognizes the
traditional "general" nature of certain components of these
reserves, while minimizing distortions caused recently by
special reserves relating to loans to highly indebted countries.
6The International Lending Supervision Act of 1983 requires
U.S. banks to establish an "allocated transfer risk reserve"
against assets whose value, as determined by the federal banking
agencies, has been impaired by a protracted inability of public
or private borrowers in a foreign country to make payments on
their external indebtedness.
7when the risk-based standard initially takes effect at the
end of 1990, loan loss reserves will be limited to 1.5 percent
of risk-weighted assets.
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It also recognizes the fungibility of the reserves, while not
attempting to isolate specific segments of the reserve and
introducing further artificial constraints.
Rather, by limiting
the amount of reserves that may be included in regulatory
capital to 1.25 percent of risk assets, the approach allows
latitude to include reserves at levels comparable to the
historical loss experience of U.S. banks. 8
8
rn order to determine the latitude provided by the
risk-based capital standard for including reserves at levels
comparable to historical experience, the following
considerations are useful:
1. The risk-based standard limits the amount of reserves
that may be included as part of tier 2 capital to 1.5 percent of
risk weighted assets from the end of 1990 to the end of 1992;
subsequently, if an alternative agreement is not reached, the
reserve ratio would decrease to 1.25 percent. (Reserves are
defined as general loan-loss reserves which may include amounts
reflecting lower valuation of assets or latent but unidentified
losses present in the balance sheet. Exceptionally and
temporarily the reserve ratio may be as high as 2.0 percent.)
2. The average ratio of loan loss reserves to total loans
for the period 1976 through 1986 was 1.14 percent for all
domestic banks and 1.10 percent for the 25 largest.
3. Bank risk weighted assets tend to exceed total loans,
as indicated by the ratio of risk weighted assets to total
assets ranging between 71 and 110 percent, in contrast to the
ratio of loans to total assets averaging between 55 percent and
66 percent from 1976-1988.
4. The 1.25 percent limit of reserves to risk weighted
assets is less restrictive than the same numeric limit based on
total loans because risk weighted assets are typically a larger
base (denominator) than total loans.
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Conclusion
The Federal Reserve Board believes that loan loss
reserves of otherwise solvent institutions should be considered
as capital, provided that the reserves are general in nature.
Accordingly, the Board fully supports the treatment of reserves,
as described in the recent risk-based capital accord.
That
understanding calls for additional study of the proper treatment
of loan loss reserves in capital, while providing a fall-back
position if no further agreement is reached.
Absent an
agreement, the reserves allowable as capital will be reduced to
1.25 percent of risk weighted assets by the end of 1992.
This
level is consistent with the traditional relation of loan loss
reserves to loans for U.S. banks.
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Appendix A
Selected ratios, insured commercial banks,
by size class
Percentages
Loan Loss Reserves
To
Total Loans
Loan Loss Reserves
To
Total E9uity
Date
Top25
All
Non25
Top25
All
1976
1977
1978
0.92
0.87
0.90
1.00
0.95
0.96
1.06
1.00
0.99
11. 29
11.09
12.04
8.72
8.63
9.09
7.69
7.65
7.94
1979
1980
1981
0.92
0.90
0.92
0.99
1.00
1.02
1.03
1.08
1.11
12.83
12.70
13.67
9.45
9.35
9.67
8.14
8.06
8.14
1982
1983
1984
1.01
1.12
1. 23
1.10
1.19
1. 24
1.17
1.24
1. 24
14.71
15.31
16.59
10.32
11. 05
12.13
8.65
9.44
10.44
2.90
3.44
3.61
2.37
2.66
2.66
1. 98
2.13
2.09
1985
1986
1987
1. 53
1. 37
1.83
4.53
1. 42
1. 64
2.71
1.54
1. 81
19.36
22.43
65.51
13.73
15.86
27.37
11.64
13.39
15.95
3.21
3.47
5.71
2.56
2.73
3.60
2.19
2.33
2.56
1988
3.89
2.41
1. 74
46.99
23.65
15.73
4.82
3.04
2.24
AVERAGE:
1976-86
1.10
1.14
1.17
14.73
10.73
9.20
3.33
2.60
2.14
AVERAGE:
1987-88
4.21
2.56
1. 78
56.25
25.51
15.84
5.26
3.32
2.40
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Non25
Nonperforming Assets
To
Total Loans
Top25
Al 1
Non25
Not Available
Appendix B
Treatment of loan loss reserves as capital in
selected major industrial countries
The size of loan loss reserves and the treatment of
the reserves as regulatory capital varies widely among foreign
countries.
A brief summary of the tax and bank regulatory
treatment of loan loss provisions and reserves by six countries
is provided below:
Canada:
reserves.
Canadian banks maintain three different types of
"Specific reserves" are maintained against losses
attributable to individual assets.
Reserves are also maintained
against loans extended to countries that have restructured their
external obligations.
Currently, banks must maintain a minimum
reserve equal to 40 percent of outstanding exposure to a group
of 38 rescheduling countries.
level is 45 percent.
doubtful assets.
The maximum permissible reserve
"General reserves" are held against
These reserves may be held against pools of
assets, and some flexibility is allowed banks in determining
doubtful assets.
Specific reserves and the reserves established
against loans to heavily indebted countries pursuant to the
Superintendent's mandated list of countries are tax-deductible.
In the case of the latter reserves, the provisions are
deductible up to 45 percent of outstanding exposure.
are not considered a part of regulatory capital.
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Reserves
France:
French banks may maintain a reserve against long-
and medium-term credits, not to exceed 5 percent of the total
relevant credits.
The annual provision to the reserve may not
exceed 5 percent of net profit before taxes.
The provisions to
the reserve are deductible for tax purposes, provided they are
taken against specific assets.
Reserves are generally
considered to be part of regulatory capital.
Germany:
German banks maintain several types of reserves.
General loan loss reserves are required by supervisory
authorities and are tax-deductible.
These reserves consist of
0.1 percent of all loans secured by mortgages, 0.505 percent of
long-term loans, guarantees and letters of credit, and 1.05
percent of unsecured short-and medium-term loans.
The
percentages are established by the supervisory authorities.
"Specific reserves" are maintained at the discretion of bank
management, based upon an assessment of individual risk factors.
Increases to these reserves are also tax-deductible.
Country-risk reserves are maintained subject to rules similar to
those applied to specific reserves.
Loan loss reserves are not
included in regulatory capital.
Japan:
General reserves are included in capital.
Loan
loss provisions are tax-deductible provided they do not exceed
either:
(1) a defined statutory percentage (0.3 percent); or (2)
the "actual" percentage of the net outstanding loans and
receivables charged-off during the period.
Switzerland:
Provisions to general reserves are
deductible for tax purposes provided they are also reported in
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the bank's financial statements.
General reserves formed in
accordance with legal requirements are included in capital,
provided they are set aside in special accounts and designated
as equity.
United Kingdom:
individual assets.
Banks maintain specific reserves against
Such provisions are made as a result of
detailed reviews of individual loans.
General reserves may also
be established to cover potential losses within existing
portfolios that have not yet been specifically identified.
Provisions to specific reserves are tax-deductible; those to the
general reserve are not.
Additionally, the Bank of England
periodically reviews the appropriate level of reserves to be
held against foreign loans with individual banks.
General loan
loss reserves are part of regulatory capital, while specific
reserves are not.
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@FedFRASER