With signs in recent months that the economy may be gaining some steam, many banks have begun reducing their Allowance for Loan and Lease Losses (ALLL) reserves to reflect these improving economic conditions. This has been one factor that has helped improve earnings at many banks. Regulators, however, are saying, “Not so fast.” They are concerned that the economy is still unsettled and banks that are reducing their ALLL based on economic conditions are being overly optimistic.

Comptroller of the Currency Thomas Curry addressed this at RMA’s Annual Risk Management Conference in November: “While reserves remain at a high level industry wide, quarterly provisions are smaller than charge-offs. In fact, if provisioning continues at current levels and charge-offs remain constant, the allowance as a share of noncurrent loans could return to historical lows in just a few years.”

Boosting Earnings
In some instances, Curry suggested, banks are lowering their ALLL simply to boost earnings. “I remain very concerned that too many institutions are continuing to reduce provisions solely to boost earnings,” he stated bluntly at the RMA conference.

The regulators believe that the rate of declining loan loss provisions and reserves across the banking industry does not jibe with the macro-economic data — high unemployment and depressed real estate values, in particular. While acknowledging that the worst of the economic crisis may be behind us, regulators are concerned that reductions in ALLL are happening too fast given the still-fragile state of the economic recovery.

In response, the OCC has warned banks not to be too aggressive when it comes to reducing ALLL in order to increase earnings. It wants banks to be aware of the fact that there is still a lot of uncertainty with the economy and they should err on the side of caution when it comes to reducing their ALLL.

Some banks, meanwhile, are countering that while lowering their ALLL does reflect optimism, these lower levels of reserves are entirely appropriate given current economic conditions. They also point out that the new formulas and models banks are now required to follow with regard to ALLL actually require them to lower reserves, whether they want to or not.

The Look-Back Period
Once again, one of the methodology sticking points between regulators and banks is the look-back period. With a good year now on the books, regulators are arguing for a longer look-back period of three to four years of data. This is the argument banks were making back before the financial crisis, but bankers now prefer a shorter look-back period of less than three years.

Curry stressed that regulators do not see an immediate problem when it comes to banks’ ALLL reductions, and bankers should not expect to be hammered by the regulators over this — at least not right now.

“But I am saying that we are watching reserves very closely, and we expect national banks and federal savings associations to maintain them at appropriate levels. We are ready to take appropriate action if and when it is needed.”

If you have questions about the appropriate level of reserves for your bank, please give us a call to discuss this in more detail 417-881-0145.