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VALUATION RESERVES FOR SECURITIES valuation msEsms K m gm m m m % ßayooad X* Sengren, Assistant Chief Dirieion of Research and Statistics ^federal Deposit Insurance Corporation Executive Ccoaittee Meeting State Bank Supervisors5 Association April 6, 1955 Yaluation Reserves for Securities You may recall at a meeting of this group a year ago, seme time waa 4*vot*& to a re-examination of loss reserve practices for securities l»ld by the commercial hanks. The guiding principles for loos reserves were expressed in the 1938 agreement and again restated in 19*»9 . It seemed appropriate, therefore, to give some thought to what had been accomplished. To sum op the discussion of last year very briefly, the bank exam ining authorities abandoned the market basis for valuing securities and shifted to the lower of book or cost in 1938. this arrangement was designed to stabilise the asset structures of the banks and to put somewhat of a damper on speculative activities. Along with the shift in the basis of valuation was the establishment of reserves to cushion the losses inherent in the Investment process. these reserves were expected to be accumulated II the profits on securities as well as from set-asides from «M«i»4ng« year. To be sure, the data on reserves are very Yragaentary. there has III a© improvement in the sources of our informationj we are obliged to with information from the condition and the earnings report forms, added details on reserves could be obtained from examination reports, but the information would be non-additive. However, I «hail up-date and summarise the details presented last year as briefly as possible because I believe the picture is d e a r enough for our purposes* the valuation reserves on securities at the d o s e of 1953 amounted to about | ^ 5 million, this compares with a total securities portfolio of around $77 billion, composed, of course, heavily of M o r a l issues— - 2 «* $63 billion— and other securities totaling $3h billion, which included about $11 billion of Municipal* • Parenthetically, I an quoting 1953 figures since the information to complete the 195* picture 1* not available. With respect to loans, the showing is $alte different. The valuation reserves for loans amounted to $960 million as coopered with $68 billion of loans, in fact, tgr the end of 195* the reserves had grown to over a billion dollars. The rate of losses and chargeoffs, according to the records, is substantially the same both for loans and securities--and remember losses and chargeoffs art combined— we cannot segregate the actual losses from the chargeoffs and chargedowas. furthermore, over a period of years, such as 19*8 to 1953# the record shows that losses and chargeoffs on loans aggregated about $560 million aa compared with a trifle over $60G million for the securities portfolios. The picture of growth in valuation reserves is very interesting, for loans over the period 19*6-1953# there was an increase from slightly more then $*00 million to almost one billion dollars. On securities, the amount of reserves at the beginning and end of the period was substantially unchanged, $233 million to $335 million, respectively. Sometimes it is argued, of course, that we need not pay much attention to valuation reserves on securities because there are profits in the for® of recoveries on securities, and the profits offset the losses. However, such initoaation as may be found in the reports suggests that the amount of recoveries on securities for the 19*6-1953 period was leas than losses and chargeoffs. The figures are in the order of $*?5 million to 3 * $600 million, respectively. So the cushion of profits Is Just not available, or at least it doesn't show up in the heat information at t let me also refresh your memory regarding a development in the life insurance field, which was mentioned a year ago* You may recall that the life insurance companies have adopted the policy of an annn*.! increment to the reserve for the protection of their securities portfolios* To he sure, it is a very small increment*»^ twentieth of one percent on ai i of their holdings* The provision for reserves involves additional complexities that I need not bother you with at this time, There is an attempt to classify assets as to basic quality with a higher set-aside on the so-called inferior grade issues, but fundamentally it is a fact that the liffe companies do recognize the process of attrition in the capital accounts. They make some provision for it each year. Also, there is a ceiling on the total reserve equal to one percent of the total securities portfolios. 3h addition profits cam be used to augment the reserve so that the total actually is building up much faster than the basic provision of onetwentieth of one percent would suggest. flie basis for this valuation reserve policy is some information about capital attrition, developed more or less as a by-product from a national Bureau of Economic Beseareh study in the field ©f corporate bonds, fhat study covered the period roughly from 1900 through to the «14-192*0*6, and the evidence was rather clear that irrespective of the quality of Issues at the time of flotation, over the long run, there is a discernible process of capital attrition. That process investors cannot ignore, m$.. the appropriate method to protect against loss is t© set up a reserve annually. With that b&ekground, It seems to as that ve should reeo^iae that it 1» impossible to solve problems»-such ae the one presented by the facts of capital attrition on investment— but it is necessary to learn to live with them* Ignoring then is the important pitfall to avoid* So for purposes of encouraging a bit of discussion, 1 propose to suggest notr that the banks might be veil advised to adopt a policy of this sort, namely, to reserve annually an amount equal to one*twentleth of one percent of their investments* As a matter of fact, I would not exclude Federal®* T© be sure, no one is going to argue that in the aggregate federal issues will cense a Ices to the banks. The fleet is that Federal portfolios turn over and banks make mistakes like everybody else. some capital losses. They are bound to run into If they turn over the securities often enough end long enough, I should be inclined to believe that an annual loss rate of a twentieth of one percent would be very modest* In addition, we mist recognise that the municipal portfolio— now the most important segment of the other securities category— is growing very fast* At the mid of 195b, it amounted to over $12 billion, an increase of 1? percent for the year* There are many elements in the municipal portfolio that are reasonably new to the investment community* ffe are going into volumes end types of financing that present problems, and I am quite confident that many of them have not been solved* The situation is quite different from ten or twenty years ago, whan the bulk of the municipal credit tended to be in the form of full faith and credit obligations of relatively small comnmities* At this point in the discussion* anyone who has the temerity to make suggestions of this sort is usually waved aside with the statement §I* that after all there Is a tax problem— and that la the «ad of that* can't do anything about a tax problem* tea Hall, certainly everyone «ho looks at the figures will agree that one of the Important forces at work to facilitate the accumulation of loss reserve on l o a m m o the favorable tax treatment accorded the annual set-asides. However, It s e e m to m that sound banking and examination policy stands on Its own legs* fbe basic policy with regard to reserves cm securities «as announced almost twenty years ago by the bank examining authorities* has ever said that It was a bad policy* It is ^ Bo m e guess that no one has paid much attention to it* To stress the tax difficulties mere or less puts the cart before the horse. If an annual provision for reserves against losses on securities is warranted, them the appropriate tax treatment will be accorded to set-asides* However, if such reserves cannot be Justified on a sound basis— without regard to taxation— then sorely one would not expect say special treatment to encourage their sccisssilatieu. Here is a ease where it may be necessary to apply the stick before the carrot in order to get sons action* Ton will recall the basic questions in this discussion a year ages Is it sound to value securities at an amortised cost basis without a valuation reserve program? to talk about* fhat s e a m to be the question that we still need If the authorities have abandoned the loss reserve principle— notwithstanding its continued existence la the published policy statements— then are there other steps that need, to be taken to restrain speculative trading?— because that was one of the objectives, furthermore, are there other safeguards that could be used to protect against capital attrition? * 6 • Finally, let me stress again that we have a more or less definitive basis for measuring capital attrition* Bow we do have a thoroughly respectable study of a very large body of investment data, and the evidence of capital attrition is reasonably clearcut. This Is ©a important development because you will recall that for many years there was literally no peg to use In hanging the hat. So I will leave those questions with you. Thank you.
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