FDIC endorses shift in loan-loss policy

November 29, 2010

Banking & Finance

By Ted Carter

Sheila Bair, the FDIC chair, says the agency thinks a healthy balance can be achieved in standards for setting aside loan-loss reserves.

“In that regard, we support moving from a probable-loss measurement of impairment to an expected-loss threshold,” she says.

This, she says, will ensure that financial institutions maintain appropriate resources on hand to absorb losses. Conceptually, loan-loss reserves should represent the credit losses inherent in an institution’s loan portfolio at any given time, while protection against unanticipated credit losses should be provided through the institution’s equity capital, Bair notes.

That’s why it’s important to move from a probable-loss measurement of impairment to an expected-loss threshold, according to Bair.

“At the same time, we do not support simply projecting a continuation of existing economic conditions when measuring expected future loss. Instead, we believe that the allowance should reflect forecast changes in economic conditions that will influence the size of those losses.”

No question FDIC-insured institutions carried inadequate levels of loan-loss reserves coming into the current economic crisis, Bair says. Provisions for loan losses have totaled more than $550 billion since the end of 2007. Yet as of mid-year, the industry’s “coverage ratio” of loan-loss reserves to non-current loans was just over 65 percent, compared with levels of more than 100 percent before the crisis.

“Now, we are seeing some of the largest institutions reduce their loan-loss reserves as their levels of problem loans diminish,” she says.

Bair says she wants banks to err on the side of caution by maintaining adequate levels of loan-loss reserves, and not rushing to draw them down while their volumes of problem loans are still at elevated levels.

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