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GAO Blames Loan-Loss Rule for Small Bank Failures

Tammy Whitehouse | June 13, 2013

The failure of more than 400 community banks through the financial crisis is partly attributable to risky lending practices, but accounting rules that limited loss provisions played an important part as well, according to the Government Accountability Office.

A GAO study of failures of small banks, or those with assets of less than $1 billion, says many of the banks that collapsed pursued aggressive growth strategies with nontraditional, riskier funding sources and weak underwriting and credit administration practices. Exacerbating the problem, the banks followed U.S. Generally Accepted Accounting Principles that required them to limit their loan loss reserves based on historical loss rates, which were readily exceeded as the real estate bubble burst. As a result, loan loss allowances were not adequate to handle the wave of credit losses that ensued, so banks had to recognize their losses through increased loan loss provisions that reduced earnings and regulatory capital, straining the banks to collapse.

The Financial Accounting Standards Board and the International Accounting Standards Board each have proposed a new accounting standard that would require banks to follow a more forward-looking approach following an expected-loss model to recognizing credit losses. The two boards could not agree, however, on exactly how the expected-loss model would work, leading to one approach for FASB, and a different approach for the IASB.

FASB has received more than 80 comment letters on its proposal, most from financial institutions, credit unions, professional associations, and others tied to the financial services sector. While many favor an expected-loss model, they call on FASB to work more closely with the IASB to achieve a converge approach and to make some significant changes to the proposal to make it more operational.

The American Bankers Association, for example, provides more than 30 pages of explanation for how both FASB's and IASB's models contain problems with their respective expected-loss approaches and how the banking profession has a model it believes already works to impair loans and emerge from loss periods. In fact, the ABA says its working group continues to study the proposal along with a related proposal on recognizing and measuring financial instruments, and continues to find issues, leading to a request for more time to submit comments. “With each new conference call, particularly on recognition and measurement, new questions are being raised,” wrote Michael Gullette, vice president of accounting and financial management for ABA.

The National Credit Union Administration says FASB's model would be unduly burdensome on small and medium-sized credit unions and would discourage them from making loans to low-income borrowers. The Conference of State Bank Supervisors says banks will benefit from a standard that enables stronger reserves as a result of forward-looking accounting, but it worries FASB's model is too difficult to implement and requires too much difficult forecasting.