Regulatory datapoint of the day, SEC edition

By Felix Salmon
June 23, 2009

JC makes a very good point in the comments on my blog entry about how new banks are no more likely to succeed than old banks: why on earth should we think, in that case, that if we tear down the SEC and start again, we’ll end up with any improvement on what we have right now?

Well, let me point you, as Exhibit A, to the SEC’s policy on loan loss reserves in general, and those of SunTrust in particular:

For more than a decade, banks have been restricted by accounting standards and the Securities and Exchange Commission from building capital reserves for loan losses that are likely to occur but difficult to predict…

Many bankers disapprove of the current rules. J.P. Morgan Chase & Co. Chairman and Chief Executive James Dimon wrote in the bank’s annual report, “I find it absurd that loan-loss reserves tend to be at their lowest point precisely when things are about to get worse.” …

In the U.S., bank regulators such as the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency would like banks to build big loan-loss reserves.

But the SEC worries that banks can use loan-loss provisions to smooth earnings.

The SEC has tussled twice with regional bank SunTrust Banks Inc. over reserves.

In 1998, when SunTrust wanted to make an acquisition, its loan-loss reserve came under SEC scrutiny.

At the time, the Atlanta bank held a reserve of $666 million, 1.6% of total loans. The SEC forced SunTrust to reduce its reserve by about $100 million because the agency felt the reserve was too high.

In 2004, the SEC took aim at SunTrust again.

The bank’s assets had doubled, and its loan-loss reserve stood at almost $1 billion, or just above 1% of loans.

The SEC criticized the company’s assumptions in building the reserve, among other things, and SunTrust fired its chief risk officer.

In other words, if the SEC hadn’t existed at all, SunTrust’s loan-loss provisions, as encouraged by the FDIC and the OCC, would have been eminently sensible. But instead the SEC forced out SunTrust’s chief risk officer, and forced the bank to book hundreds of millions of dollars of loan-loss reserves as operating profit, during the healthy times when any prudent bank should be beefing up its loan-loss reserves in anticipation that at some point in the future, the economic environment won’t be quite as healthy.

So yes, scrapping the whole thing and starting again might not do much good. But hey, at least it would stop the SEC from causing active harm.

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Comments
3 comments so far

If profits go to retained earnings instead of a loan loss reserve what’s the difference? You just reverse the flow when loan losses increase. There would be a difference if profits were paid out in the form of dividends but I don’t believe that happened. Net, net there shouldn’t be any effect on overall solvency.

Tom,
That’s true only if the bank then does not assume more liabilities. As we’ve seen in banking recently, more equity more more opporutunities to leverage that equity. Thus, when the inevitable losses occur, the bank then becomes overleveraged without sufficient reserves.

Posted by Mitch | Report as abusive

One man’s “prudent… beefing up… [of] reserves in anticipation… [of a less healthy] economic environment” is another man’s cookie jar earnings-smoothing shenanigans.

I guess I come down closer to the side of the SEC in this particular case, which should not be interpreted as an endorsement. Perhaps because I never bought the argument that accounting rules can be somehow “pro-cyclical” (whatever that means).

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