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U.S. House of Representatives,
Subcommittee on Financial Institutions and Consumer Credit,
Committee on Banking and Financial Services,
Washington, DC.

    The subcommittee met, pursuant to call, at 10:05 a.m., in room 2128, Rayburn House Office Building, Hon. Marge Roukema, [chairwoman of the subcommittee], presiding.

    Present: Chairwoman Roukema; Representatives Barr, Kelly, Vento, Bentsen, Sherman, and Moore.

    Chairwoman ROUKEMA. I am going to bring this hearing to order here. We do expect a few more Members; hopefully, they will be here shortly.

    In any case, I welcome our panelists and our audience here today. It is a very important issue and one that deserves a full and complete airing and study.

    I think, from my point of view—I want to be very clear that loan loss reserves is not an academic subject, in my opinion. It is not a subject about whose jurisdiction this is. It is both an accounting issue and a safety and soundness issue. That is fundamentally my focus and my reason for calling this hearing.
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    We have to make an attempt here—you have been reading the press as well as I have, but we have to make the attempt to clear the air surrounding the loan loss reserve accounting issues that have erupted since last November when the SEC required SunTrust to restate its financial statements. There has been, since that time, a significant amount of concern and confusion regarding what the standards are for loan loss reserves.

    While there have been efforts in the last six months to resolve the issue on an interagency basis, there is in fact, as a result, more uncertainty today because of the varying interpretations regarding the effect, if any, that the FASB Viewpoints article focused on as existing guidance.

    I have got to say that the SEC has—and I want to be clear about this—the statutory authority to set accounting standards for publicly held companies, including banks and bank holding companies.

    In 1991, the Congress, through FDICIA, required the Federal banking agencies to apply GAAP or stricter accounting standards to financial institutions. This statutory cross-referencing has created a great need, an intense need, for the agencies to work together. But again, unfortunately, we are here today with a lot of gaps, if you will excuse the reference, a lot of gaps in our understanding.

    I firmly believe that it is not responsible for the Federal Government to provide conflicting signals for a highly regulated industry regarding core financial standards. This sets up a regulatory whipsaw which potentially undermines safety and soundness. I, for one, see investor protection and safety and soundness as compatible. That is what we are going to see today. Are they incompatible?
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    The hearing will give all the parties, FASB, SEC, the Federal banking agencies and the American Institute for Certified Public Accountants, a chance to state their positions, and hopefully—I haven't been successful so far, but hopefully we can find common ground.

    It is also very clear to me that there has been a lack of agency coordination. The agencies have issued two interagency statements on loan losses in the last six months, and this would seem to indicate that they were at least attempting to work together. But recent news articles and letters to Congress make it clear that the agencies—there has not been enough coordination. We here in Congress expect the Federal agencies to work together, come to agreement on issues that are cross-jurisdictional.

    Here is where we bring it right up to a specific and current issue: One of the hallmarks of H.R. 10, as I understand it, is supposed to be interagency coordination. Loan loss reserves is one of those issues which requires the agencies to work together, and I would hope that we can find that common ground and a way of doing that, or else we may need to write it into law; and I could not possibly predict how that would come out.

    The issue of loan loss reserves is not new nor does it need to be complicated, in my opinion. Financial institutions monitor their loan portfolios and set aside a reserve to offset the loans which will not be collected. The bank then charges loan losses to the loan loss reserve. We understand that.

    Loan loss reserves, along with capital, help to cushion the financial health of a financial institution when significant losses are experienced, especially during down economic periods.
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    These reserves are perfectly appropriate and permissible under generally accepted accounting principles, the GAAP as we know it.

    As we will hear from FASB and AICPA, the GAAP does not provide a clear, fixed formula for establishing loan loss reserves. Bank management and accountants are supposed to exercise significant judgment and discretion based on a loan loss reserve and a wide range of loan loss reserves would be permissable under GAAP. However, SEC Chairman Levitt believes public companies are manipulating their financial statements to meet stock market analysts' earning forecasts.

    The SEC has raised questions as to whether or not some financial institutions are engaging in what they call earnings management by padding the loan loss reserves during good economic times. His point is that investors and the markets are misled by earnings management.

    It is unclear as to whether or not that case is being made, and, therefore, we have witnesses on Panel 3, a bank stock analyst who is going to testify that there is no ''transparency issue,'' or ''investor protection'' issue here. He believes that there is sufficient disclosure of loan loss reserve practices, and his position is that analysts are aware of the different reserve practices of banks and that is factored into their earnings forecast.

    Banking agencies and the industry have voiced significant concerns about the SEC's unilateral actions in this area, and quite frankly, I too am concerned about the lack of coordination, especially with respect to that particular Viewpoints article. The SEC needs to be sensitive to the concerns of the banking agencies, but I think we all in this room know that. The question is how we meet those concerns.
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    We will hear today a great deal about accounting transparency and investor protection. We have three panels of witnesses, all of whom I believe have important points of view to contribute to our understanding.

    I just want to say before I move to Mr. Vento and his opening remarks that I would like to make a couple of points to identify my focus, if it isn't already clear.

    One issue that I am concerned about is the economic trends and how this is factored into GAAP and the standards for establishing loan loss reserves. I, for one, believe in the business cycle, even though we haven't had much of a cycle recently, fortunately, and I appreciate that. The banking agencies keep very close tabs on both regional as well as national economic activity, and that is appropriate.

    As all of us know, the economy is in the ninth year of expansion, and it is an economic record for the United States. But while we are all not wishing for an end to the good economy, we do believe that there is still relevance to the business cycle, and that should be taken into account, that there is a possibility of a downward slide in economic activity, as well as a rise in bad loans, and they are important in our total discussion.

    The Viewpoints article seems to say that banks cannot establish loan loss reserves for expected future losses. That is a question mark. That seems to be something that is intimated here.

    On the other hand, the 1993 interagency statement issued by all banking agencies, and I believe reviewed and commented upon by the SEC, directs banks to take into account current environmental trends such as local, regional or industry-specific slowdowns when establishing those reserve standards.
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    I will be most interested to hear what our witnesses have to say about the economic trends and whether or not expected future losses can or should be included in these loan loss reserves.

    In closing—and here I note that there was some publication this morning that made reference to this. In closing, I would want the SEC to address the issue of the June 30th deadline for banks to make the transition adjustment called for in the Viewpoints article. June 30th is almost here, and as I have noted, there is significant confusion among bankers and accountants regarding the effects of that Viewpoints article.

    Some bankers and accountants, out of an abundance of caution, may lower reserves just to avoid a problem. Even if such adjustment is necessary, even if it should prove to be necessary or appropriate, but based on the confusion, I would like the SEC to consider extending the deadline for making that transition adjustment. I would like to see how they could address this specific issue, since it seems to be the crux of the immediate problem and what might be seen to be an arbitrary deadline.

    With that, I will defer to my Ranking Member, Mr. Vento.

    Mr. VENTO. Thank you, Madam Chairwoman, for bringing together this hearing—it is very timely—on loan loss reserve. While complex and seemingly arcane, the interpretation of GAAP with regards to loan loss reserves is profound in its implications and its impact on institutions, investors and the taxpayers.

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    Frankly, accounting has never been more interesting. But just for a moment, one serious—the past decade's events certainly underline the importance of accounting which I approach, as a matter of fact, with a healthy skepticism with regards to this issue; that is, if I can especially take you back to the thrilling days of yesterday when the Federal Home Loan Bank Board implemented regulatory accounting practices, obviously the poster child for the Federal Standards Accounting Board for what can happen when regulators are left on their own, I guess; and of course, much to the dismay of the Members of Congress, and second, of course, not to leave the accountants off the hook, I can remember the accountants' litany of explanations was that their acceptance of GAAP numbers was spoon-fed to them by the various institutions and not looking beyond the black and white numbers.

    I don't know. I can remember those protestations and even some regulators today that were involved as salespersons for various institutions at that time to try to gloss over some of the problems. But it is kind of painful, isn't it?

    So if I am somewhat sanguine to this 1998–99 debate, it is because of the cures of—well, I would say probably a memory of performance under challenge.

    You know, fast forward to today, based on press reports, letters and other information I have seen, it seems in this instance the tail may be wagging the dog. But protestations to the contrary, notwithstanding the Federal Accounting Standards Board Viewpoints article and the actions of the SEC with regards to questioning financial institutions' loan loss reserve policies are having an effect on financial institutions who feel they are being given mixed messages with regards to determining adequate loan loss reserves.

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    Bank regulators urge caution based on the business cycle and increased credit risk and subprime lending. While the signals from the Federal Accounting Standards Board and the SEC suggest that reserves are too high, under the existing methodology and implementation of the standard—standards, incidentally, that came under intense review apparently in 1975 and 1993—the perception of the April 1999 Viewpoints interpretation of FASB and Number 5 and FASB Number 114 has been bolstered because the article suggests that banks could make transition adjustments. That basically sounds like a fix to me, prior to the close of the second quarter of 1999.

    It is hard to swallow that this does not represent a change in interpretation or even the standards as it requires a transition adjustment, a one-time grace period not to restate prior earnings in the second quarter of 1999. How that jibes with the joint meetings that you had in March of 1999 I will leave to your own explanation. To say the least, I think if I had been sitting at that March meeting and picked up this Viewpoints article in April, I would be confused.

    I am confused. I don't for a minute deny the authority of the Federal Accounting Standards Board or the SEC to have earnings stated properly and to be properly accounted for. But it is one thing to agree to something in March and then to come out with something that is going to be implemented in the second quarter of May and suggest that the whole backdrop of this is, there is going to be a 24-month period in which you are going to work this out. It sounds to me like somebody has been co-opted.

    Madam Chairwoman, there is a lot of money at stake here. But beyond the dollars is the cost of credibility of the regulators, management; the accountants for institutions are at risk. Future business plans may be negatively impacted by today's uncertainty and mixed signals. I am more than hopeful that at this hearing we can bring some clarity to the issue and bring the regulators together for an interagency agreement that will have a longer shelf life than the last two agreements.
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    While I certainly do not condone the use of reserves to manage earnings, adequate loan loss reserves are a key part of the banking safety and soundness, as the Chairwoman underlined. To require changes in them when the appropriate bank regulator has a well-defined policy which accounting policies have historically accepted, I guess, is a big source of concern, because the role of reserves as a hedge against credit risk protects investors, depositors and the deposit insurance fund.

    So we all have something at stake, and frankly, you know, the regulators, I think in at least the past decade, have stepped up and done the job. I think the effort to try and reconcile this has hopefully been in good faith by all concerned, but I am left with the events and actions and facts which seem to be going in opposite directions from the rhetoric and from some of the agreements.

    I welcome all of our witnesses and look forward to their testimony and dialogue and the question and answers that we will have for them today.

    Thank you, Madam Chairwoman.

    Chairwoman ROUKEMA. Thank you, Mr. Vento.

    Before we hear from our first panel, I would simply state the usual administrative standards that we use here, procedural standards. First of all, all our witnesses will have written testimony, their written testimony is automatically included in the official record of the hearing. Our time constraints are such that we know that you frequently have to condense and consolidate your oral testimony. But your official testimony will be included in the record.
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    Members will also have the normal ability to submit written questions to our witnesses for follow-up, written responses if they so desire. The hearing will remain open for the usual period of time for submission of additional information.

    In this regard, we have received, just recently, letters from the Financial Services Roundtable and the Conference of State Banking Supervisors on the subject of loan loss reserves, and I would like to ask unanimous consent to include for the record this documentation, as well as other submissions from various groups in the hearing record. If there is no objection to that, that is the normal procedure.

    I would like to announce, unfortunately for me—not for you, but for me—that I will have to leave this hearing momentarily because of an unavoidable conflict with a markup in another subcommittee, the Education and the Workforce Committee, where I am deeply involved in ERISA reform and health care protections—that markup that will be commencing momentarily.

    Fortunately for you, we have the good services and offices of Congresswoman Sue Kelly, who has consented to be Chairwoman in my absence and conduct this hearing.

    I will leave it to her to introduce our first panel.

    Mrs. KELLY. [Presiding]. Thank you very much. Madam Chairwoman, I understand that Mr. Barr has an opening statement. May we accept that?
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    Chairwoman ROUKEMA. I am sorry, I was not informed of that. If you would like to take the chair, please, and then I would be more than happy to have Mr. Barr make his opening statement.

    Mrs. KELLY. Thank you, Madam Chairwoman.

    Mr. BARR. Thank you, Madam Chairwoman. I would like to commend Chairwoman Roukema for exercising her subcommittee jurisdiction and holding this hearing in such a timely manner.

    Madam Chairwoman, as you and others know, the issues raised at today's hearing arose last year when it was reported that SunTrust Banks, after a two-month review process by the SEC, was required to restate its earnings upward by $100 million. During the investigation, the SEC began to question the ''excessive reserves at predominantly conservative banks.'' this finding sent a ripple effect across the financial services community.

    In my opinion, the SEC has overstepped its authority by attempting to coerce banks into adopting less conservative lending practices than they, in the interests of their customers and the overall soundness of the banking industry, would practice. What the SEC may discourage as ''aggressively reserving funds'' the bank regulators and others may support as conservatively supporting.

    There is broad agreement among the industry that an accurate earnings picture is, in fact, vital for our financial institutions to operate successfully. I am not aware of any complaints filed by bank analysts alleging dishonest or misleading financial reports by the banks. Moreover, the bank regulators reviewed bank records and found that they complied with all current laws and regulations.
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    When it became clear that the SEC was acting without the support of the appropriate banking regulators, I wrote to Chairman Leach asking that hearings be held to look into the SEC's findings that some banks had been improperly reserving for future losses. It seems clear the SEC is engaged in underhanded tactics.

    Today's testimony is written notwithstanding, resulting in at least one bank restating its earnings from 1994 to 1996, thereby cutting its reserves by $100 million.

    The SEC's inquiry into the ''excess reserves'' at some banks is the first time, in recent history at least, that the Commission has judged a bank's reserves to be too large and argued that overreserving for future loan losses makes it difficult for investors to understand the true profit picture.

    Madam Chairwoman, as you and I were told back in March during the markup of H.R. 10, the SEC and bank regulators have been working together to publish a joint clarification on banks' loan loss reserves. This clarification was to include the methodology and rules, as well as documentation and disclosure requirements to help guide banks. However, that clarification has never reached a consensus.

    Taking their own initiative, the SEC pushed for the recent issuance of the Financial Accounting Standards Board Clarifying Rule on Statement Number 5, Accounting for Contingencies, and Number 114, Accounting by Creditors for Impairment of a Loan, published on October 12 of this year. The FASB clarification was meant to help guide the generally accepted accounting principles, or GAAP. Instead, the rule seems to have left banks in a state of confusion.
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    This is distressing. This present confusion over excessive reserve amounts creates a disincentive for banks to maintain the necessary protection against today's fluctuating economy. Unfortunately, banks are receiving conflicting signals concerning loan loss withholdings by two different interest groups, the SEC and the bank regulators.

    Aren't we supposed to learn from our mistakes? Shouldn't we? One need only look to the savings and loan debacle in the 1980's to understand the need to create a clear and concise, uniform standard regarding loan loss reserves.

    The safety and soundness of our banking industry is vitally important to our economy, and it is obvious that the SEC's mandate does not reflect common sense or the well-being of the American people. The financial security and lifetime savings of millions of Americans depend on the ability of banks to establish and follow safe lending practices. Maintaining adequate and realistic loan loss reserves is a key part of that process.

    Any concerns the SEC might have with the market value of financial institutions must be reasonable, based on common sense and arrived at in conjunction with the banks and the bank regulators. Moreover, these loan loss reserve guidelines must not be allowed to become the tail wagging the regulatory dog, seen as important—more important than the goal of protecting the banks' basic financial soundness.

    Hopefully, the SEC will end its efforts to force banks to drop their conservative, well-based and sound lending practices, at least without clear congressional action. If not, I urge we examine legislative remedies.
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    Thank you, Madam Chairwoman.

    Mrs. KELLY. Thank you, Mr. Barr.

    Is there anyone on this side?

    Mr. Sherman.

    Mr. SHERMAN. I thought I had last dealt with FASB when I left the practice of accounting.

    One thing to keep in mind is that different accounting reports or statements can be created for different purposes. One kind of accounting system is mandated by the Internal Revenue Code, which is designed to make sure that companies do not understate earnings, except it allows deductions for various items that we want to provide, as to which we want to provide incentives.

    A second kind of report, a generally accepted accounting principles report submitted to shareholders, is designed to allow shareholders to evaluate the company as a potential investment; and the focus of those reports, although there is a balance sheet, is the income statement, where the slightest change in quarterly earnings can send a stock in one direction or another.

    A third type of accounting report submitted by most regulated businesses is regulatory—is prepared according to regulatory accounting principles, RAP. Unfortunately for this industry, RAP has gotten a bad rap, and that is because in the last decade, instead of the regulators insisting upon more conservative statements, they allowed less conservative statements to be used; and needless to say, the solvency of the savings and loan industry was not achieved.
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    Looking, though, at the purpose of RAP, the purpose of whatever accounting statements are used by the bank regulators, there is no such thing as excessive reserves from the standpoint of the bank regulator. So one thing that I hope we explore in these hearings is to give meaning to the provision of law that says that the regulators cannot allow more liberal accounting methods than required by GAAP, which, of course, allows them to use more conservative methods. In this way, regulators could insist upon whatever level of reserves higher than GAAP is necessary to ensure solvency.

    This makes sense because from a regulatory point of view, the focus is not on this or that quarter's earnings, but rather on the soundness of the balance sheet.

    The second comment I would like to make is the need for transparency, because I have met people on various sides of this issue, and I thought I was at a glassmaker's convention, because transparency was applauded with such crystal-clear argumentation. I am sorry—my fault.

    But transparency means two things. First, it means banks being transparent with shareholders and potential shareholders into what their income actually is based upon, not the most conservative conceivable reserve, but rather the best reserve that can be published under generally accepted accounting principles.

    At the same time, as FASB and the SEC are urging banks to be transparent, it is time that we have the maximum possible transparency in the FASB process.

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    I am concerned when an article written by some staff members at FASB creates such a stir. By very definition, those articles are supposed to be boring, and trust me, most of them achieve that objective. When an article like that achieves this kind of notoriety, then at least in the view of some, it is breaking new ground. And whether it is the Government with an Administrative Procedures Act, or FASB with its own procedures, there is supposed to be transparency and input and procedures.

    You don't have that when an article is published.

    So I hope the first panel, especially, will tell us that we are going to see all of FASB's rules adhered to, we are going to see industry involved in whatever is done, and we are going to have transparency in the process of creating transparency.

    Thank you, Madam Chairwoman.

    Mrs. KELLY. Thank you very much, Mr. Sherman.

    Does anyone else have a statement they would like to make? Thank you very much.

    I would also in the interest of time like to ask unanimous consent to insert my own statement in the record. Hearing no objection, so ordered.

    Our first panel today is the Securities and Exchange Commission and the Financial Accounting Standards Board. Testifying on behalf of the SEC is the General Counsel, Mr. Harvey Goldschmid.
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    Welcome, Mr. Goldschmid.

    Mr. Goldschmid has been the General Counsel since July of 1998. Prior to joining the Commission, Mr. Goldschmid was the Dwight Professor of Law at Columbia University Law School. Mr. Goldschmid was also of counsel to the law firm of Arnold & Porter between 1995 and 1998.

    Mr. Goldschmid has testified before the Banking Committee this year already, and we welcome you again, sir.

    Testifying on behalf of Financial Accounting Standards Board is Mr. Timothy Lucas. Mr. Lucas is the Director of Research and Technical Activities at the FASB.

    Mr. Lucas, we welcome you also and look forward to your testimony. Thank you, gentleman. Please begin.

    Mr. GOLDSCHMID. Should I go first?

    Mrs. KELLY. You may toss a coin, whichever.


    Mr. GOLDSCHMID. I would be happy to go first. It is good to be back before this subcommittee.
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    Congresswoman Kelly, Congressman Vento, Members of the subcommittee, thank you for the opportunity to testify on behalf of the Securities and Exchange Commission on appropriate financial reporting for loan loss allowances.

    As I hope to make clear this morning, the SEC's efforts are based on a simple, but profoundly important principle: Our financial markets work best when they have access to transparent—that is a wonderful word for us—transparent financial reporting. Good numbers are indispensable to making our financial system work.

    At the outset, let me be absolutely clear about one point that has been raised by a number of the statements made: The SEC does not want, nor has it ever wanted, financial institutions to artificially lower conservative or prudent loan loss allowances or ever to have inadequate allowances. But we do care, as Chairman Levitt recently said, that banks—and I would add, all other public companies—follow GAAP. That is a fundamental standard on which there is universal agreement among the banking regulators, I think, and the SEC. This is common ground.

    GAAP is the backbone of high-quality financial reporting and provides the transparency and rigor investors and markets demand. Indeed, Congress recognized the wisdom of that approach in the aftermath of the S&L crisis.

    This morning, I have got to continue to stress the importance of financial transparency. I would like to indicate what the SEC is doing and what we are not doing to ensure that is achieved.
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    I also want to review the joint efforts undertaken with banking regulators to address our areas of mutual concern in a way that ultimately strengthens our financial system.

    The SEC's statutory mandate is to ensure full and complete disclosure to investors and the marketplace. The principle of full disclosure goes to the very heart of the strength of the United States capital markets, and we dare not minimize it or lose sight of the importance to investor confidence and market integrity.

    One need only look at the savings and loan crisis of the 1980's and the recent experience in Asia, where disclosure took a back seat to manipulation and expediency, to learn our lessons. Markets need timely and reliable information to be efficient and effective. Depriving them of this critical ingredient undermines their ability to discipline those who fail to deploy capital effectively or to invest it wisely.

    Without accurate information, shareholders cannot properly assess the financial performance of a company or the level of risk they are undertaking. This is a very important point. Boards can't effectively discharge their oversight responsibilities or stop mistakes early in the process.

    Let us not forget that a loan loss allowance is not cash or capital. Rather, it is management's best judgment of the amount of loan losses that have already been incurred by a bank. That is critical information to a market attempting to assess the quality and health of a bank's loan loss portfolio.

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    I have been asked why the SEC, when reviewing bank filings, questions the financial statements of institutions that have been reviewed by its banking supervisor. Banking regulators are tasked with ensuring safety and soundness of financial institutions. We agree and, of course, we applaud that task; we have to protect the public interest. But clearly that mission cannot be seen as mutually exclusive from the SEC's duty to ensure transparency in financial reporting. The depositors, investors and lenders are all essential to the fabric that makes our financial system work.

    Let me turn quickly to what the SEC is not doing, contrary to what has been inaccurately reported or rumored. First, I state again, we do not want financial institutions to artificially lower reserves. In fact, as we agreed with the bank regulators on March 10, we recognize that in today's unstable global markets, it is likely they may have to increase the reserves if their portfolios warrant. We embrace the notion that there a high degree of managerial judgment that must be exercised in establishing loan loss allowances and that the resulting estimate will be a range rather than a number.

    Second, there has never been a hit list of financial institutions targeted by the SEC. We treat banking institutions and all others basically in the same way.

    In recent months, the SEC and banking regulators have agreed upon a number of important steps. Through the creation of a joint working group, we have made a lot of progress. To a great extent, we have relied on and will continue to rely on the private sector, the FASB and the AICPA, to develop the right answers to many questions. The FASB Viewpoints article is simply a reflection of what is in the March 10 statement from the SEC and the banking regulators, indicating that the FASB and the AICPA would provide elaboration on the Standards 5 and 114.
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    But we have to continue to work with the private sector. We must respect the private sector standard-setting process that has served the Nation well for 60 years. It is clear that the objectivity and fairness in standard-setting can only be guaranteed if this process is insulated from special interests.

    As Chairman Greenspan stated, the success of the U.S. Accounting model has been due in no small part to the private sector's significant involvement in the process, which is credible and impartial.

    I pledge the SEC will continue to do its part to build on what we have achieved thus far. I believe we are working well and creatively with the banking regulators.

    Thank you. I, of course, would be open and happy to take questions.

    Mrs. KELLY. Thank you very much, Mr. Goldschmid.

    Mr. Lucas.


    Mr. LUCAS. Thank you, Madam Chairwoman.
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    Members of the subcommittee, I am Tim Lucas, Director of Research and Technical Activities for the FASB. With me are my associates and coauthors of the Viewpoints article, Leslie Seidman, Assistant Director, and Sean Leonard, a Practice Fellow. The FASB staff appreciates the opportunity to be here to discuss with the subcommittee the April 12th, 1999, Viewpoints article.

    Since 1973, the FASB has been the designated organization in the private sector for the establishment of standards of financial accounting and reporting, that is, the core of what is referred to as GAAP, or generally accepted accounting principles.

    The FASB is an independent organization, funded entirely by the private sector. Our mission is to establish and improve standards of financial accounting and reporting. The FASB's principal objective and primary reason for being is to maintain and improve the usefulness, credibility and transparency of financial reports. A central tenet of that mission is that credible, transparent financial statements are critically important to our markets and to our economy.

    We operate under rules of procedure that require an extensive due process for any new standards. The rules are modeled on the Federal Administrative Procedures Act. They include open meetings of the Board, comment periods and public hearings.

    Under those rules, we developed FASB Statement Number 5, Accounting for Contingencies, in 1975, and Statement Number 114, Accounting by Creditors for Impairment of a Loan, in 1993.
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    Those statements provide general principles that a creditor should apply to accounts for the impairment of a loan portfolio. Those statements apply to all companies that extend credit; they are not peculiar to banks.

    To illustrate, as part of the due process leading to Statement 114, we held seventeen public meetings preceding an exposure draft; we received one-hundred-sixty comment letters, seventeen organizations presented views during public hearings, four entities participated in a field test, and members of the Board visited with other entities to discuss the exposure draft.

    We held nine additional public hearings redeliberating the issues, following the exposure process, before the final statement was issued.

    In addition to the basic standards, the Board works to maintain and improve the quality of financial reports in other ways. There are a number of those other ways, but one vehicle we have used on a number of occasions is the publication of an article. Publishing an article is often a timely and effective method of communicating our views to help constituents appropriately apply the standards that have been issued. An article is not a standard and cannot change a standard, but it can in some cases help to communicate what the standard requires.

    We have published a number of such articles on various topics, including earlier articles on both Statement 5 and Statement 114. Members of the FASB review all articles that are written by the staff on existing standards.

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    We had three specific objectives in the April 12th Viewpoints article. First, we wanted to answer some detailed technical questions that had been raised about how the two standards interact or work together.

    Second, we decided to update the earlier articles for changes that had occurred in the literature since the issuance of those articles.

    Third, we decided we needed to remind readers of the basic underlying principle that had been established in Statement 5 in 1975; that is, that losses can only be recognized under generally accepted accounting principles when current information indicates that the loss has already been incurred.

    The FASB staff does not ordinarily ask for comments from constituents on drafts of articles. However, in this case, we decided to seek comments from a number of knowledgeable constituents, because we thought they would be able to help us enhance the clarity and readability of the article. We circulated two different drafts of the article to the Emerging Issues Task Force, the members of the AICPA committee that will be represented here later today, the chief accountants of the banking regulatory agencies and the Securities and Exchange Commission staff.

    We carefully considered the comments that we got and we concluded that that process significantly improved the clarity of the final article.

    We certainly accept that the article does not answer all of the questions that our constituents had about loan loss accounting. We were very careful to limit the questions addressed to those that are dealt with in the underlying statements. Again, we were not setting a new standard.
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    The AICPA Allowance for Loan Loss Task Force is working to address some of those remaining questions. Any standard emerging from that project will receive full due process. The FASB is participating in that and is fully supportive of those efforts.

    I would be happy to address any questions you would like to address to me. Thank you.

    Mrs. KELLY. Thank you very much, Mr. Lucas.

    I have a couple of questions that I would like to ask of you, Mr. Lucas.

    Members of the AICPA Task Force, the banking regulators and many in the banking industry expressed their concern to you and the SEC about the Viewpoints article. Was there an intent, for some reason, for the FASB not to circulate the Viewpoints article for broad industry comment?

    I heard what you said, but I have a question about how broad that draft was, before the finalization of that draft, how broadly that was transmitted to the industry and how much of that comment that came back was actually accepted before the article was done?

    Mr. LUCAS. As I noted, we did seek comments more broadly than we ordinarily do for an article. There were perhaps—I don't have an exact number, but 20 or 25 people from various groups that were involved in that, and some of them undoubtedly passed it on or had groups of people within their organization look at it.
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    Some of those we consulted suggested we should subject the paper to full due process, which would have made it not an article, but a statement, a new standard or an interpretation. We concluded that we should do that if we thought the article would change practice. We concluded that our first objective, that is, clarifying how 5 and 114 relate to one another, would not in all probability cause significant changes in the numbers or the amounts of loan loss reserves.

    This is on the order of a technical detail, and I think it would qualify as boring under most definitions.

    The final objective though, the third one, reminding readers again that Statement 5 does not allow booking a cushion for future losses, in our view, should not have been needed at all. That has been GAAP for 24 years; it is not unclear; it should not be confusing. But we decided to include that item in the article, and I think that may be one of the ones people are pointing to. If anything in the article is changing practice, it would be that conclusion or reiteration of the primary idea in Statement 5 that you can't book future losses, you have to have presently incurred losses as a basis for the GAAP reserve.

    We decided to include that in the package—it is Question 14 in the article itself—because we were concerned about some of the things we had read in the press, and I will give you two examples. An American Banker article in October, October 26th, 1998, includes a quote from the chief financial officer of a major bank holding company, and it says, ''In the good times, we should be able to reserve for the bad times.''

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    Now, we believe that that is contrary to the clear intent of Statement 5, which again has been GAAP for many years.

    More recently, in yesterday's American Banker, which is an article about these hearings that are being held, a representative of the ABA has a remark attributed to her that says also the FASB failed to clarify the question of whether or not banks may reserve for losses that are likely to occur in the future.

    Well, that is the question we were very much trying to clarify. I guess we didn't succeed completely. But these indicated that there was some uncertainty about a very fundamental principle that we thought was well established, so we decided we should publish the article to try and clear up some of that confusion.

    Mrs. KELLY. Thank you, Mr. Lucas.

    One of the other questions I had was, the business cycle is well documented, and the accounting rules in the loan loss areas don't, to me, seem to take the business cycle into account. Why is that?

    Mr. LUCAS. I think that is correct. The Chair in her introductory remarks referred to safety and soundness and the fact that loan loss reserves and capital are critical to safety and soundness. It is the sum of those that is, in some sense, available to cushion future events.

    We believe, as Mr. Goldschmid said, that in measuring income, it is critical to have a reserve that reflects events that have been incurred, that have already happened. The capital is then also available as a cushion, and unless you have done an accurate job, or a reasonable job, of estimating—and we certainly concur with the comments that indicate that judgment is necessary—unless you have done a reasonable job of measuring that, you don't know how much capital you have available.
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    So we believe one of the things that contributes to safety and soundness is reliable, credible information about how much loss has already been incurred and how much capital, therefore, is available.

    Mrs. KELLY. Thank you very much.

    Mr. Goldschmid, I have a question for you. The banking regulators issued a joint agency guidance on loan reserves in 1993. The guidance tells banks and examiners to apply GAAP to loan loss reserves. All of them say that the SEC and FASB reviewed, commented upon and confirmed that the guidance was consistent with GAAP.

    Has the SEC changed its mind on this?

    Mr. GOLDSCHMID. That, of course, is before my time.

    Now as I understand it, the important statement in that 1993 statement was the agreement that GAAP is the way to go in terms of financial reporting. There are invariably nuances of difference. There were comments from the SEC that indicated nuances of difference.

    The key there is GAAP, that was reaffirmed in November of 1998 and reaffirmed again on March 10 and, I hope, will be reaffirmed again today, that core is there, and there is common and basic agreement.

    Ms. KELLY. Thank you very much.
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    Mr. Vento.

    Mr. VENTO. Thanks, Madam Chairwoman. I think, Mr. Lucas, that obviously the concerns you articulate, the hearing and input that occurred in 1993 and 1995, or 1975, with Rule 5 and Rule 114, I guess—the concern, of course, is I don't remember—you don't remember, in the latter instance at least, the type of attention that had been focused on it, as is being focused today on this issue. So it seems to me that there is rather remarkable change.

    Mr. Lucas, I would point out that the Viewpoints article has a disclaimer on the back which indicates the views expressed are solely those of the authors.

    The SEC turned this in to GAAP through their May 20th pronouncement, at least for the second quarter. It seems to me, this takes on a lot more relevance. It may just be a viewpoint, obviously, put out with a lot of comment and consideration.

    Doesn't this really, in a sense, circumvent the usual due process for establishing an accounting rule, reinterpretation or guidance—if I am using the wrong semantics, I guess they have different meanings, but obviously you understand from a layman's perspective.

    Mr. LUCAS. The Viewpoints article, as originally issued, was, with the disclaimer, simply the views of the authors, although it was the views of the authors after some considerable consultation on the part of Board members and outsiders.
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    Mr. VENTO. I grant you that.

    Mr. LUCAS. Subsequently, however, Viewpoints was discussed by the Emerging Issues Task Force, which is a group that has been set up to try to supplement the guidance issued by the Board on a timely basis, and the consensus positions of the Emerging Issues Task Force have the force of generally accepted accounting principles.

    There a process they do go through; it is not as extensive as the Board's process for a new standard. The EITF, as we call it, is constrained to stay within the constraints of the written literature that the Board has published. That group, the EITF, accepted the article as a useful addition to the EITF literature, and it was in that context that the SEC was then asked about transition.

    Mr. VENTO. I think the problem here, putting the tennis ball back in your court, Mr. Goldschmid, is after sitting down at this March 9th meeting—I don't know what transpired; I know what transpired, but you obviously sat down to work together—all of a sudden now we have a guidance out; is that the right term?

    Mr. GOLDSCHMID. That is right.

    Mr. VENTO. That says as of the second quarter of 1999 you have a safe harbor if you do this. That is, you don't have to go through restating earnings and doing a lot of other work with regards to redrafting your accounting for the last couple of years if you make these particular changes.
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    Obviously this is, I guess you looked at this as not as significant as some of the objects of your affection.

    Mr. GOLDSCHMID. Well, let me step back to the March 10 agreement, that was very carefully thought through and worked through by banking agencies and the SEC. A key point in that agreement was that we all would adhere to guidance that we knew was coming from FASB and the AICPA.

    The emphasis I had in my opening statement about the private independent standards is critical to how our system works. These are not SEC rules. These are rules put down by FASB, which has input from the accounting profession, the banking profession, industry in general, investors. This system works well because it is in the private sector and because of what FASB did. So it wasn't a shock.

    We had an idea at the time, originally, when FASB came down with the Viewpoints article, that does become part of GAAP if it goes to the Emerging Issues Task Force.

    We had been asked by several accounting and banking organizations, ''If we need to change, how should we do that?'' We responded in the May 20 letter by our chief accountant saying, ''Here is the easy, sensible and traditional way to make any change if needed.'' Now, the statement from the banking regulators suggests there may be very little change needed, but if there was change needed, the responsible answer for us is to tell people how to do it and indeed tell them how to do it in a constructive, easy way rather than have to face restatement.

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    Mr. VENTO. I am struck with the statement here it says, you know, that the agencies will work together to encourage and support the Financial Accounting Standard Board process in providing additional guidance regarding accounting for allowances for loan losses, and somehow that has eluded you. I notice the Federal Reserve Board, Mr. Meyer, seems to try to put the best face on it as possible; but clearly, you know, it has not been the viewpoint—or should I say the viewpoint, bad word—the opinion of the others that are affected by what it is doing.

    My time has almost run out, but I do have a question that goes further than this, and that is the SFAS 114, and I point to the statement in your—the sentence in your statement, Mr. Goldschmid, and this is a question for you, Mr. Lucas. It says, ''We recognize that certain aspects of GAAP require further clarification. For example, we recognize that it may be difficult to distinguish probable losses inherent in the loan portfolio as of the balance sheet date for possible or future losses, not inherent in the portfolio of that date.'' The OCC states that, of course, a little different because they point out that as the FAS Number 114 requires that a bank estimate future cash flows in assessing whether a loan is impaired and the amount of the loan loss reserve that should be provided, and of course, much of the confusion, they go on to state in their testimony today, revolves around the issue, and additional guidance is clearly needed to assist banks in developing.

    So this still leaves sort of a subjective issue out there that has not been resolved and seems to me is at the core of what the problem is here in terms of how we state earnings or how we deal with the loan loss reserve, and that still is eluded, Mr. Goldschmid points out in the testimony.

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    And so the question to you, Mr. Lucas, is this particular discrepancy or this disparity between what is happening here and what you are presenting.

    Mr. LUCAS. I don't think that it does. We fully accept that there is considerable room for further useful guidance, particularly on best practices within the range of generally accepted accounting principles in this area, and that is why we are working with the AICPA Task Force who will be represented here later. They have a number of perfectly legitimate and entirely appropriate questions that they may well be able to deal with to further clarify how to apply GAAP. The Viewpoints article was only intended to state the limits that are defined by Statements 5 and 114. The further guidance will happen within those limits or could possibly lead to suggestions that the board ought to change those limits through due process.

    Mr. VENTO. I think that the SEC second quarter rule obviously jumps ahead or circumvents that particular issue to try to deal with the guidance.

    Mr. LUCAS. As Mr. Goldschmid said, that would be only if somebody needs to make an adjustment because of Viewpoints, and in that case, it is a fact that they have not been following generally accepted accounting principles appropriately that have been established for a long time.

    Mr. VENTO. Well, you define them—my time has elapsed—I mean, you are defining them, and I think it is all wrapped, I think it is the same piece of cloth in my view, and I think of those that are affecting the regulators that have to regulate, feel it is all part of the same piece of cloth and so I think that is the concern here.

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    Mr. GOLDSCHMID. May I drop a footnote on that?

    Mr. VENTO. Yes.

    Mr. GOLDSCHMID. As with any complex issue, there is a core of the guidance in 114 and in 5 that everybody accepts and understands. There are some difficult, open issues. When we gathered with the bank regulators we understood that, as does FASB; and that is why, again, if you look at that March 10th statement, we indicate that the AICPA Task Force would be resolving and elaborating on some of those issues, and FASB of course would review that, but these are fringe issues. I mean, they are important and we want to get them resolved. Indeed, what we have been doing over the past year is working with the bank regulators, working with the standards-setters to try to move forward, to try to get as much clarified as humanly possible and as quickly as we can.

    The staff at the agencies, the banking agencies and the SEC, have been meeting more than weekly to try to get guidance out on documentation, on disclosure, on other things. We are working extremely hard to make this area as clear as we can. On complex issues, we have got to give that AICPA task force time. They really are not at the heart, but at the edges. There are some very complex issues. As a lawyer I am getting a very broad education on accounting, and I discovered to my surprise that it is at least as complex as law.

    Mr. VENTO. Well, I will come back at another time. Thank you, Mr. Goldschmid. We will obviously have the prerogative, Madam Chairwoman, to submit written questions to our witnesses, I presume, without objection?

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    Mrs. KELLY. Without objection, so ordered. Thank you, Mr. Vento.

    We are taking people in the order in which they arrive, following standard practice.

    Mr. Bentsen.

    Mr. BENTSEN. Thank you, Madam Chairwoman.

    Mr. Goldschmid, I have a couple of questions for you. One is, I understand in using the analogy to the S&L prices, if allowances are being underreported or reserves are being underreported. What I don't understand is, why would a public company overreport reserves and deduct from earnings? Why would that be in the interest of a company to decrease earnings in that regard?

    Mr. GOLDSCHMID. Let me explain the dangers, and that may explain the reason to you. For some, what has been true of my parents, putting extra reserves, as much as possible in a reserve, sounds like it is good, the more the better for that rainy day. One danger is for shareholders. They will not know the true value of the bank if there are greatly excessive reserves. The shareholder would read the balance sheet—perhaps the most sophisticated analyst might see through—but, the shareholder would read the balance sheet in suggesting that bank is worth much less than it really is.

    Two, management may have that reserve to begin to feed in when things go bad. Now, that is the most destructive, potential danger in the whole process. If things begin to go bad, it may be shareholders, market discipline, the market's work here. And even the outside directors, the independent members of the board, may not know things are going wrong. The signals of capitalism that tell the markets and tell the board when things begin to go bad will not be there and the ability to correct early, to change course, to do good things will not be there also.
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    Mr. BENTSEN. But two things. If you are an investor and you are looking at a stock of a company, I can see the problem where you might say ''Acme Bank Corporation's earnings are not that great, so I am not going to invest in Acme, I am going to invest in X, Y and Z Bank Corp., and it is because I wasn't able to look through the excessive loan loss reserves that they had.'' That is a problem for Acme Bank Corp., I think, in getting a fair stock price. It is not necessarily for the investor, and I don't understand the analogy that somehow being too conservative creates some sort of blind eye toward what is going on in the world around you that you somehow get caught up in it.

    Mr. GOLDSCHMID. Rather than talk about U.S. banks, let me give you an analogy from a discussion with a senior German banker who said, ''I don't understand your system. If things begin to go bad here, we have hidden reserves that will shield us from the bumps, people will not know.'' Now, among the people who will not know will be shareholders, will be regulators at times, will be markets that discipline with a value of stock, will be directors who could stop something from going wrong. In part, that was the problem in Japan where nobody knew how bad things were.

    Mr. BENTSEN. I understand that, but this isn't the Japanese banking system, and this isn't the German banking system, and I think we are finding out more and more that we have a better banking system than both of those countries, far different than what we thought ten or fifteen years ago.

    And furthermore, while you may not be able to decipher the balance sheet, or everyone may not be able to decipher the balance sheet or management's discussion and analysis, I still don't see your analogy as working.
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    Let me ask another question before I lose my time, though. In your testimony you go through a number of things that your staff looks at in filings, I guess, 10Qs, Ks and IPO filings, where there may be a discrepancy that occurs, and there is a whole list of—you call them disclosure and documentation issues that you go through. The fourth—most of them look rather objective in terms of something doesn't match up between management's discussion and the balance sheet, and that seems to make sense, and you would kick that back and say this is—you either erred here or whatever.

    But the fourth, you state that ''instances where allowances were in excess of the range documented credit losses inherent in the portfolio.'' Is that more of a subjective viewpoint on the part of the SEC staff that, in your analysis of the portfolio, that perhaps the bank was either being too conservative or too liberal in their allowance, or is there a mathematical concept associated with that as well? And I guess my question is, is that the role of the SEC or is that stepping into the role of the bank regulators? That is the problem we have dealt with.

    Mr. GOLDSCHMID. It is a very fair question. We don't second-guess bank managements on loan loss policy, on making judgments. If they make a judgment, as I said, we embrace the idea. There is a lot of judgment that is managerial judgment and we defer to it. Where the issue comes up in the way that the SEC has to look at it under GAAP is you may have a situation, for instance, where there is a contradiction. The management discussion analysis says, ''Our loan portfolio is in the best shape in our history, it is terrific, it is growing, it is safe,'' and yet they have tripled their reserves. At that point we have to say, ''How can you triple it? Can you explain it?''
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    In the dialogues that go on with a given issue, we will then ask, ''Can you document this? Does this make any sense? Was there an analysis?'' It is only at that level that we get into the—we do not evaluate. If banks make bad loans, that is up to them. God hopes they don't, or I hope they don't, but we only work with disclosure, not with their ability to loan.

    Mr. BENTSEN. I know my time is up, but you go through one where you look at their methodology, you go through two where you don't, they fully explain their reasons so you want more verbiage. You go through three where there is an inconsistency between the verbiage and the methodology; but four, it still seems to me that if once you have gone through all of those that then you say, ''I am just curious as to whether or not you are saying we are not sure we agree with all of what you said and have given us, even though you matched everything.''

    Mr. GOLDSCHMID. It won't be a matter of we disagree with your judgment. It will be what was your analytical framework? What was your way of calculating this? Do you have documentation? It is that level we are talking about. We don't second-guess banks as to how much a given loan is worth in general.

    Mr. BENTSEN. Thank you, Madam Chairwoman.

    Mrs. KELLY. Thank you very much, Mr. Bentsen.

    Mr. Sherman.
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    Mr. SHERMAN. Mr. Goldschmid, I heard part of your testimony, and it surprised me so much that I had to get some of my fellow CPAs outside the room because you seem to be saying—matter of fact, you did, I think, actually use words to the effect that you don't have a reserve unless there has been an occurrence, until the loss has been incurred, and in fact, had you really said that, that would have been a shaking departure from at least the accounting that I am familiar with, in that every company has an allowance for—not every company, the vast majority of companies in and out of the banking industry have an allowance for doubtful accounts, based upon the size of their accounts receivable or loans receivable and the experience that they expect, and at least if those I talked to outside the room put me straight, you are not saying that there should be no allowance for doubtful accounts?

    Mr. GOLDSCHMID. Oh no.

    Mr. SHERMAN. OK. You had me worried there for a while.

    Mr. GOLDSCHMID. I should explain. As I indicated, I am a law professor, a lawyer by background, not an accountant, and Jerry Hawke, the Comptroller of the Currency, has spent a fair number of breakfasts saying, ''What do they really mean when they talk about probable loss?''; and this is part of what the AICPA will be defining, and refining, but we certainly allow loan loss allowances—indeed I want to make that clear.

    Mr. SHERMAN. I have got a number of other questions, but I don't think there is any doubt that if a bank makes a million loans to a million consumers, and we all send in our checks on time and we are all, you know, for the first month that the bank doesn't have to produce financial statements on the assumption that all one million of us will pay off our mortgages without a single default, because that is unlikely to occur.
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    I do want to make sure I have got the context correctly, and that is, usually corporations want to overstate their net worth and overstate their income. That is not what the banking industry or elements of it are being accused of here. Nor, I think to be accurate, are they being accused of trying to understate income or understate net worth over a long period of time. What you folks have quoted are statements to the effect that bankers in Germany can and bankers in America might like to manage earnings. That is to say, over a decade or a century, absolutely accurately, report earnings, bad debt expense, allowance for doubtful accounts, all these items over a century would be absolutely accurate. But there are those who would like to understate for the market the volatility of banking, and banking can be a very volatile business.

    The concern that I have is that we are all the way up into the triple digits on FASB's statements, and we as of yet haven't published something that doesn't have an awful lot of managerial judgment, and then your fear that that managerial judgment gets conservative in the good years and liberal in the bad years so as to understate the volatility of the bank's operations.

    What I would like to focus on here, though, is how quickly a FASB, or at least interpretation, is going to be issued that will be part of a transparent process so the industry will be able to feel that, you know, they haven't been submarined by an article, but rather the full administrative process has been gone through.

    Mr. LUCAS. Referring to the AICPA Task Force's project, I don't know exactly what their schedule is, but I would estimate that it might be a couple of years perhaps before it could be finalized because the process that you are referring to obviously takes time.
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    Mr. SHERMAN. The other point I would like to make is this: is how important an article is versus the FASB statement itself. Let's say, in the ultimate enforcement of all this or one of the biggest ultimate enforcements—and I will ask Madam Chairwoman, can I continue with one more question?

    Mrs. KELLY. Go right ahead.

    Mr. SHERMAN. OK. The ultimate enforcement is through our tort system where we could imagine a situation where the finder of facts is convinced that the financial statements correctly reflect the language in the FASB statement but they were not prepared consistently with the article. Under those circumstances, do we find for the plaintiff; or under those circumstances does the fact that the financial statements conform to the FASB statement, is that proof that they were prepared under generally accepted accounting principles?

    Mr. LUCAS. That sounds like a legal question, but you have been doing accounting questions.

    Mr. GOLDSCHMID. Go ahead.

    Mr. SHERMAN. No. That is really an accounting—alleged accounting negligence question.

    Mr. LUCAS. If we have done the appropriate job of drafting the article, and a lot of it is actually quotes out of the statements themselves, that disparity probably shouldn't occur. To the extent that it does, the fact that this went through the emerging issues task force process and was thereby included in the literature as a clarification would give it some standing of its own on the hierarchy of generally accepted accounted principles.
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    Mr. SHERMAN. But would have far less dignity than the statements.

    Mr. LUCAS. Right. If there was a clear conflict which would represent an error in the article, if we have something that contradicts what is in the statements then that would be—we are quite confident we don't have that because a lot of people look for it, but if that was the case, then the standard would rule.

    Mr. SHERMAN. And your article, though, would have far more dignity than two or three professors writing articles in various journals?

    Mr. LUCAS. Only because of the EITF process that we put it through.

    Mr. SHERMAN. Thank you.

    Mrs. KELLY. Mr. Sherman, have you finished?

    Mr. SHERMAN. Yes.

    Mrs. KELLY. Thank you very much. Mr. Baker has stepped out for a moment, so we will go to Mrs. Maloney.

    Mrs. MALONEY. What I don't understand is why don't you just follow the regular procedure, and if you want a new rule, issue a new rule, instead of having an article that is now being interpreted. You know, what I'm understanding, some people are, before you even get to the substance, are objecting to the process; and it seems to me that it would be, you know, what we call in the House, we call it regular order: You know, do things the regular way; and if some people say you are reinventing an article, why don't you just go back and just if you want to give a new rule, give a new rule and let everybody comment on it and follow, the ''regular order''?
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    Mr. GOLDSCHMID. I will do my accounting role. Let me explain at least what I think happens. This is not like Harvey Goldschmid writing an article for the Columbia Law Review. This is the way the accounting profession gets out information, but it can only be clarifications or elaborations, not changes, to all of the constituencies: the business community, investors, the accounting profession. It is a relatively elaborate process, but it can go quickly. And so this article cannot change GAAP. What it can do is clarify and explain, and it is done with considerable thought, considerable review, in this case considerable exposure, to all of the interested constituencies.

    The problem is that a FASB rule may take a year or two years and if you can't reach something that has come up and is troubling the business community earlier, there is a problem. Tim, is that fair?

    Mr. LUCAS. Yes. The bottom line is this is not a new rule. This is Statement 5, which was implemented with full due process in 1975.

    Mrs. MALONEY. So you are not changing anything you are saying?

    Mr. LUCAS. We are not changing the rules. We may be changing people's behavior to the extent they were not previously fully cognizant of or following those rules.

    Mrs. MALONEY. So you are changing ''behavior''?

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    Mr. LUCAS. I don't know that. The question that was raised in terms of transition was if somebody has their eyes opened by this article to what the rules have been all along, that might cause a changed behavior.

    Mr. GOLDSCHMID. In the best of worlds, everyone out there understood what FASB understood and the Viewpoints article understood and nothing will change.

    Mrs. MALONEY. Well, we wouldn't be having this hearing if everybody agreed with the article and agreed that you weren't absolutely doing anything. You know, I just respectfully feel like why don't we just follow regular order since you are, in your own words, you may be, ''changing behavior''; I can't think of—one of the hardest things to change in life is behavior. I mean, we have whole psychology courses on how to change behavior. I mean, I think wouldn't it be simpler to just issue a rule, maybe put a timeframe on it and say ''We would like comments back within a month or two months'' and then come back in a regular order way, where all the involved institutions and regulatory bodies and even Members of Congress could comment officially on the record?

    It just seems to me a neater way to do things as opposed to writing an article that clarifies the way GAAP does things. This isn't GAAP. This is standards. This is banking. We have got the greatest banking system in the world, and we learn that every day when we see the problems that Germany and Japan have. So why don't we just do things the way we have done it? And it seems to me like what is so threatening about having, you know, the input following the regular order? I mean that, to me, I think would be a fair way to follow through with this.

    Mr. GOLDSCHMID. Well, I guess if I can just comment on that briefly. This is the regular order, as I understand the FASB and GAAP process. This takes place hundreds of times. There are books published every year of these so-called articles and questions and answers. This is, in fact, the way the profession gets guidance.
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    Mr. LUCAS. On the details.

    Mr. GOLDSCHMID. Yeah.

    Mrs. MALONEY. Let me just get back on how it is done. Isn't it unusual for the SEC to endorse an FASB Viewpoints article as being GAAP? I mean, this seems, you know—I am not used to GAAP being interpreted by printed articles myself. Can you tell me how many times in the last ten years the SEC chief accountant has taken this highly unusual step?

    Mr. GOLDSCHMID. I don't think—again, maybe my limited background, but I don't think this is unusual. GAAP normally comes out through Viewpoints articles where adjustments have to be made. This is the normal process. We don't endorse this. This is FASB putting this out. It is a clarification we accepted.

    Mrs. MALONEY. OK. Well then——

    Mr. GOLDSCHMID. A standards-setting process is so important, we and all others within the community simply accept what they have done as long as it is within a very broad ballpark.

    Mrs. MALONEY. Well, if you can get back in writing to me, since you are saying you don't think, but you are not giving me a fact. I would just like to know factually how many times in the last ten years the SEC chief accountant has endorsed a FASB Viewpoints article as being GAAP. I mean, to me, it sounds unusual. To me, I think it would be easier to follow—just issuing a new rule, get everybody's input and then move forward in a studied way.
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    Mr. GOLDSCHMID. We will provide you with that information, but my understanding is that almost everyone in the profession accepts this as the way it is done.

    Mrs. MALONEY. You know, the banking agencies all believe that prior consultation by the SEC with the agencies on loan loss reserve comments would promote a more consistent application of GAAP. And well, do you or the SEC oppose prior consultation? See, you are saying everybody agrees, but I am hearing from many people who disagree. They don't see anything wrong with prior consultation by the SEC with the agencies on loan loss comments.

    Mrs. KELLY. The gentlewoman's time has ended. Would you like to have more time?

    Mrs. MALONEY. No. I would just like to hear his response, and then I appreciate the consideration of the Chairlady. I want to be fair to my other colleagues.

    Mr. GOLDSCHMID. I should warn it is not as short as you might like. Let me explain the problem. Roughly 150 comment letters go out to banks and financial institutions from the SEC any given year. Most of those will go out with relatively small comments: ''Why do you say 'possible' when GAAP says 'probable'? Can you explain your disclosure?'' In an exchange back and forth they are quickly worked out. If we tried to share every one of those comment letters with bank regulators, it would be wasteful, time-consuming, a terrible waste for everyone concerned, including banks.

    In my time at the SEC, any time there has been an important matter of policy, a bank restating, a major look at reserves, we have coordinated with the bank regulator involved. I think we would always do so.
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    Mrs. KELLY. Thank you very much.

    Mr. Baker, you have been very patient, and while you are not a Member of this subcommittee, you are a Member of the full committee and a very respected colleague of my mine. Would you like to speak?

    Mr. BAKER. Madam Chairwoman, I appreciate your courtesy very much. Thank you.

    Mr. Goldschmid, how long have you been in your capacity as counsel to the SEC?

    Mr. GOLDSCHMID. July 1, 1998.

    Mr. BAKER. So you would not be able to, from personal knowledge, comment on what I am about to ask, but let me restate it for the record in any event.

    I am understanding that Statement 5 was issued in 1975, which stipulates to the general contingency treatment for pools of loans. Statement 114 was issued in 1993 and that particular statement was issued by banking regulators with regard to GAAP and loan loss reserves as an element of that statement. And I am informed that the SEC and FASB reviewed that regulatory issuance prior to the time it was released and it was deemed to be then consistent with GAAP standards. Do you know if that is correct?

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    Mr. GOLDSCHMID. Basically, that is my understanding, with this qualification. When we reviewed that statement, the core was the acceptance of GAAP. There were nuances which we questioned, but invariably in this area there are nuances that have been questioned.

    Mr. BAKER. Yes, it seems to be full of those. Given the fact that in this particular case the Viewpoints statement was one issued apparently without industry input, there being no particular formal mechanism for reviewer comment in this case, since it was not a rulemaking process, merely an opinion opined in the publication, it would appear that even the limited comment opportunity afforded by FASB's procedural guidelines have been basically averted.

    As you know perhaps, even with your brief association in this capacity, I had some legislation which FASB had a mild concern about last year which dealt with transparency of derivative treatment and would have simply required the approval or review by public comment at the SEC of FASB's action. I find it interesting that you appear here on behalf of the SEC in defense of a FASB regulation, since historically you have, as an agency, remained at arm's length from FASB's permutations.

    I just want to, for the record—and I know Mr. Jenkins will be calling soon—establish that I think this issue brings to bear again some concern and that in light of Mrs. Maloney's comments earlier, having some mechanism by which the affected parties with regard to Governmental regulation may at least express their opinions concerning a FASB proposal, seems to be very warranted.

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    Let me put it this way. As I understand the view, it is OK to have a loan loss reserve as long as it is a probable, likely, or deemed to be an occurring event within the near term. If you take that rule and apply it to a market development of just last fall when fourteen very large institutions and some very smart people invested large sums of money in LTCM, if you went on historic performance data, there were not two days of back-to-back losses in the 3 1/2-year lifespan of LTCM until the cataclysm. If you had been an investor or a lender and using the current proposed loan loss reserves analysis, it would be in my view very questionable as to whether or not someone could reserve against the potential of LTCM losses, therefore, probably deepening the crisis as opposed to averting taxpayer loss.

    It seems as though you are saying with this rule that it is better to have your stock values written down appropriately for the prospective investor than it is for management to take a prospective precautionary view of market conditions and put the money aside in case of an economic downturn.

    How is that in the public's best interest?

    Mr. GOLDSCHMID. Well, you asked several things. Let me comment on them. One, the FASB process I think is critical. This may be conservative on my part, but I think FASB and the private sector, the way it is done, does it better than the Government ever would, and I applaud Chairman Greenspan's statement, as I indicated earlier, indicating the importance to our accounting and financial system of the FASB process. It is the process that is critical and I think it works well.

    The danger of overreserving is the danger that we won't know if those reserves are misused when things begin to go bad. It becomes the German system or a system of a type where the signaling, not only to shareholders and investors, but to the markets in terms of discipline, to boards of directors who might be able to stop a management that is going bad, all of those begin to fail. That is potentially very costly.
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    Mr. BAKER. Let me interject, because my time will expire here in just a second. I know the subcommittee wants to move on. In the 1980's, given my perspective from Louisiana and the S&L crisis, capital adequacy was the issue. You are now telling me we are having it in capital which is not sufficient to meet economic downturns, that we also want to complicate that by limiting management's perspective of potential risk. How is having less money set aside to the detriment of the investor?

    Mr. GOLDSCHMID. The whole system is geared to an immense amount, to a large amount—we talk about a high degree of managerial judgment being involved. Also, I should note in my testimony on page 26, note 53, I indicate clearly that management in properly using GAAP, can take account of all kinds of environmental factors, what kind of industry, what kind of geography, what kind of economic situation, agricultural loans today may be at greater risk, loans in various nations may be in greater risk. Our March 10th statement with the bank agencies made clear, ''If there is greater risk in your portfolio, for God's sake increase your reserves.''

    Mr. BAKER. Given that position, have you been in the capacity of reviewing any one of the financial institutions involved with LTCM; given the historic performance, given the names of the people involved, given the market circumstance, there would have been no way anyone could have predicted—had this been the case, at least the Federal Reserve, the FDIC, somebody would have jumped up and said, ''Wait a minute, look at these guys.'' All the professional analysis prior to the failure of LTCM indicated we had a safe and sound investment portfolio which would not lead anyone who was prudent, using common sense, to put additional reserves aside for potential losses.
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    The fact that there was perhaps some excess loan loss reserves minimized the potential losses that could have disrupted the entire financial marketplace.

    Mr. GOLDSCHMID. Well, the answer to that would have been to put it in capital. If you want to put extra in, don't put it where it is disguised and no one will understand it and management will be able to hide downturns. Put it in capital where it belongs.

    Mr. BAKER. It would seem to me that disclosure of a loan loss, as opposed to having it in capital, does provide the transparency an investor wants to have, because you are identifying this pot of money may be lost because of a lack of appropriate performance. How is that less truthful than putting it in capital?

    Mr. GOLDSCHMID. My fear is that when you say, ''Well, there could be a downturn, no one could know it, no one knows how to do it by methodology, no one knows how to document it, let's stick it in there,'' that isn't transparent. That is going to do far more harm than good in the long run.

    Mr. BAKER. Well, we appear to have a disagreement again. Thank you.

    Mr. GOLDSCHMID. Thank you.

    Mr. BAKER. Thank you, Madam Chairwoman.

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    Mrs. KELLY. Thank you very much, Mr. Baker.

    With Mr. Vento's permission, I would like to ask one question for Chairwoman Roukema, and that is: Why did the SEC suggest banks make the one-time change to its reserves—that is the transition adjustment wording—in the first fiscal quarter ending after May 20th? For most banks this would be June 30th. Considering recent confusion among the banking regulators and the banking industry as to the interpretation of the FASB Viewpoints article, would you oppose extending this date?

    Mr. GOLDSCHMID. Well, let me answer that this way. The FASB Viewpoints piece came out on April 12 as I remember it. That has allowed for a fair amount of review and analysis as to whether any change should be made. Therefore, it was perfectly appropriate; and actually, this was the easy and consistent way to suggest on May 20 that changes should be made in the quarter. If a bank for some reason is having trouble, and there are serious reasons why it needs an extra quarter, we are not inflexible on this. They should call the Chief Accountant, Lynn Turner, at the SEC, and he would certainly be open to discussion.

    Mrs. KELLY. I thank you very much, but I would really like to see perhaps you consider something beyond that, because we wouldn't be holding this hearing if everybody understood. So I appreciate the fact that you are willing to have an openness about that. Thank you very much, and I want to thank you, panel, for—yes, I am sorry.

    Mr. BENTSEN. May I ask another question?

    Mrs. KELLY. Without objection.
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    Mr. BENTSEN. Again, I think that the SEC, and I don't mean to beat up on the SEC, I tend to—in some respects am more pro-SEC on this subcommittee than some other Members, and I know you get a better hearing across the street than you do here. And I understand that your review for disclosure purposes borders between objective and subjective review, and in the case of public companies, particularly non-financial companies, you are about the only regulatory agency that does so, at least governmental regulatory agency.

    In the case of the banking industry or the thrift industry, there is dual regulation and maybe this is the world functional regulation that we have talked so much about on this subcommittee and the problems that are inherent in that. But you are again in your testimony, on page 16, at the end of the carry-over paragraph, you state, ''An issue is instances where allowances were in excess of the range of documented credit losses inherent in the portfolio,'' and that reads to me to be very subjective. That is not a question of a number on page 10 didn't match management's discussion and analysis. That means to me—seems to say to me that as far as the SEC is concerned, or the staff of the SEC is concerned, that we just don't agree with your methodology. And the problem there that we have to resolve is that the banking regulators may have agreed with that methodology. And so you are now not just questioning the public company, which I understand, but you are also questioning the regulators. Now, I think that has to be resolved.

    And the other thing I would say in response to Mr. Baker's questions, you seem to be saying, and this may be a misunderstanding on our part, we in many respects don't have the knowledge in these areas as you do, but you seem to be saying—I still don't think you made the case of why overstating reserves or overstating the allowance is somehow uneconomical or not conservative, maybe uneconomical may be inefficient for the company in valuing their stock properly, but to err on the side of being too conservative in setting up reserves, you seem to almost be stating, and you have brought up capital, that maybe the allowance and the loan loss reserves structure doesn't work anyway, that it is a meaningless issue. If you really wanted to be more conservative, increase capital, forget about loan loss reserves. That is the impression you left me with, in response to Mr. Baker's comment.
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    While again not clearly stating—and even bringing up Germany and Japan, who are under different regulatory systems—not clearly stating why it was conserving too much for risk today put you at greater risk tomorrow.

    Mr. GOLDSCHMID. Well, let me start by saying, again, management has very large degrees of judgment in this area, and we defer to it. The language you read about probable losses inherent in the portfolio is not our language. That is GAAP language. That is language the bank regulators and everyone else agrees with. We have all been doing that for many years now, and including the statements in November of 1998 and in March of 1999.

    Mr. BENTSEN. Does that language give you the ability to second-guess the bank regulators?

    Mr. GOLDSCHMID. We don't second-guess, as I indicated, in terms of the value of a loan. Banks say, ''We think this has been impaired by $10, it is a $100 loan,'' we generally will accept that. If they have no methodology, no documentation, no basis for saying that, that is when we have a problem.

    Mr. BENTSEN. And you state that in the other areas, but that is not—in one, two, and three; but four seems to go beyond.

    Mr. GOLDSCHMID. Four is not meant to go beyond that kind of analysis.

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    Mr. BENTSEN. And with respect to loan loss reserves are you stating that they really have no weight or——

    Mr. GOLDSCHMID. Well, again, on high loan loss reserves, high being extreme, beyond what you can justify, beyond what is rational, if I can put it, my parents putting it in the cookie jar for the times that are bad, those are harmful we believe. Those can be harmful to shareholders. I am a shareholder selling that stock, I am not going to get present value. If things begin to go bad at that bank, market discipline, the ability of stock markets to work, the ability of boards to see what is going wrong, the ability of our capitalist system to discipline and work will be inhibited and maybe badly hurt. That would be a mistake.

    Mr. BENTSEN. Why?

    Mr. GOLDSCHMID. They won't know it.

    Mr. BENTSEN. Because they save too much and then they get run over by the way they save too much ahead of time.

    Mr. GOLDSCHMID. Because they are hiding when things are going bad; because they are hiding that they are making bad loans; because they are hiding there is some inefficiency in the bank; because the capitalist system works well; because when things begin to go bad, including the board, including the regulators, including the market, including the shareholders know it. That is critical to making our financial markets work.

    Mr. BENTSEN. My time is up. I completely understand that and subscribe to that theory, except for I don't understand how being conservative in setting up reserves today makes you somehow miss the market in the future, which is what you are saying, I think.
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    Mr. GOLDSCHMID. Well, being conservative is like having an extra $100 million that I can hide failings later when it is extreme; that is the problem.

    Mr. VENTO. Well, Madam Chairwoman, I was just going to ask a couple of questions. I think, first of all, on the earnings issue, an accurate statement of earnings, I don't think anyone can disagree, but that sort of gets back to what does 114 really mean, which of course—but on the immediate issue, the question that Chairwoman Roukema directed Representative Kelly to present to you—I mean, there is no crisis right now, and there is substantial concern, and you seem to be suggesting and we—I think that is helpful on a case-by-case basis that you want to deal with it; but to me, Mr. Goldschmid, it seems perhaps more important that rather than, you know, implementing this or having it implemented in a piecemeal basis in terms of institutions, that you might—it might be more helpful to do something in a general way that would at least have the opportunity for input and consistency with regards to its application and eliminating misunderstandings.

    Mr. GOLDSCHMID. Well, we will think about it, but right now there may be no cases. I mean, this may be a lot about nothing. I mean, the question is whether anyone is going to have to use that process that was set up.

    Mr. VENTO. You don't anticipate there is some sort of crisis that you are averting right now by virtue of this? Obviously, I think banks are in relatively good condition, maybe by the accident of the good economy or whatever.

    The other question that I think all of us get at in terms of the issue is that if this guidance is put forth, what is your relationship going to be with the appropriate banking regulators, whether it be the Fed or the OCC or various State regulators, when and if you raise significant issues with the banks loan loss reserves?
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    I mean, it seems to me that the question here is that—you suggest in one case that nothing really needs to be done, but you insist upon questioning the earnings versus loan loss reserve issue. And if, in fact, there is going to be substantial challenge or issue raised with regards to that as we go forward, what is your relationship going to be with the regulators? Are they going to be brought in before or after or are you going to deal with this on a bank-by-bank basis, too?

    Mr. GOLDSCHMID. Well, Congressman Vento, I think that is a fair question. Other than the run of the mill situation, these 150 were a quick exchange with the issue wherein disclosure is correct, that kind of thing; if it is a restatement, if it is a significant matter as you stated, certainly in my time and I hope it will be continuing, we will confer with the bank regulators involved.

    Mr. VENTO. To, in fact, try and provide for some guidance and some option for the proper accounting to be implemented; is that correct?

    Mr. GOLDSCHMID. We are working very hard with the bank regulators. This process we set up in November and March is working. We are moving forward. We hope guidance will be coming from the working groups. There is a joint working group process. There are subcommittees meeting. FASB is looking at aspects. The AICPA is looking at aspects. We hope new and continued and quality guidance will continue to come.

    Mr. VENTO. Thank you, Madam Chairwoman.

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    Mrs. KELLY. Mr. Sherman.

    Mr. SHERMAN. If I could just have one minute.

    Mrs. KELLY. Yes, please, just one minute.

    Mr. SHERMAN. I want to comment on Mr. Bentsen's comments that, well, it is no harm, no foul, if you overstate the reserves. I think from a regulatory accounting perspective where the focus is on the balance sheet huge reserves just means fewer bank failures, that is fine, but when we look at reports to shareholders which is what GAAP's all about, and when we—then the focus is on the income statement, and the concern here is not excessive reserves. The concern here is that the reserves—because we are not dealing with a situation where we are going to have this statement amount of excess in the reserve account year after year after year. If a bank just consistently overstated its reserve by $100 million and did that for a century, its income statement would be fine.

    The concern here is that the reserves will be overstated in the good years and understated in the bad years, actually not even understated, maybe just properly stated. Well, that isn't a problem for the purpose of regulatory accounting, but it is certainly a problem for the purpose of shareholder accounting and GAAP, because it means that in the good year the bank understated its income by say $100 million, and instead of showing that $100 million as income, snuck it into the account; and then the next year, when they lose $100 million, they take it out of the account and put it on the income statement.

    So we don't want to be in a situation where we don't have objective standards. Now, I am not sure that FASB has written objective standards or can write them or is writing them with the degree of transparency process that we would like to see, but we need objective standards so that you don't have this managing of earnings.
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    The other concern that we ought to have is that if several different banks all apply subjective standards, then bank A will have excessive reserves, bank B will be—might have excessive reserves or will be rumored to have excessive reserves, bank C will have appropriate reserves, and who will know which stock to buy? The insiders who take the CFOs out get the information. All of us sitting at home should have the same financial statements, and we shouldn't have to guess which bank is using what level of subjectivity.

    So I commend you for your efforts to develop objective standards. I do think we need them. Excessive or fluctuating reserves are not helpful to the system, at least the shareholder accounting system. And I look forward to hearing from the next panel as to whether you have been clear and transparent in your process of achieving it.

    Mrs. KELLY. Thank you very much, Mr. Goldschmid.

    Mr. Inslee, have you a statement?

    Mr. INSLEE. I pass. Thank you.

    Mrs. KELLY. Mr. Baker, have you?

    Mr. BAKER. Just a couple. I appreciate your courtesy. I know we have drug this out fairly extensively. Just a couple of points.

    Mr. Goldschmid, is there a presumption by FASB that loan loss reserves are being intentionally mismanaged by financial institutions?
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    Mr. GOLDSCHMID. FASB will have to answer for itself, but we have no such assumption.

    Mr. BAKER. Is there any information you have in defense of the new proposal that the rule will correct an accounting practice that has been inappropriate?

    Mr. GOLDSCHMID. I am sorry?

    Mr. BAKER. Do you have any information or data or historical evidence that would lead FASB to conclude that loan loss reserves have been improperly utilized?

    Mr. GOLDSCHMID. We know they were low in the 1980's, but right now we are——

    Mr. BAKER. I can't let that pass. We know they were low in the 1980's, and if we had this in effect, they would have been lower, but please continue.

    Mr. GOLDSCHMID. But the point for us is that we are looking at this industry no different from any other. There is no hit list, no suspicions.

    Mr. BAKER. Oh, no. I am not suggesting that FASB would be, ''after somebody.'' I am just trying to get the premise on which this new proposal was based, and there is not historical data. There is not a belief that something is wrong, we just decided to do this.
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    Mr. GOLDSCHMID. Oh, FASB, I think, and Tim Lucas will speak for himself and FASB, but FASB I think was simply reacting to the need for clarification which is a traditional part of the FASB process.

    Mr. BAKER. OK. Let me, because the Chairman is going to jump us both in a minute because we have been unduly long. As I understood your rationale for the need for this, in response to Mr. Bentsen, we are saying that the manipulation of loan loss reserves shields an unwary investor from true financial condition. Loan loss reserves, as I understand it, come from a couple of places; either dividends you do not give to shareholders but you keep in a sack, or capital which is regulatorily required that you take away from capital and identify it as a loan loss reserve pot. Typically, just typically, I would assume loan loss reserves, maybe one percent of loans, ballpark.

    So what you are saying as your justification for this change in rule is that a bank might run through its 1 percent of loan loss reserves in order to hide losses from the investor before it gets to capital, before it depletes its earnings. Now, how big a threat is 1 percent of loan balance as opposed to the threat of not reserving against losses and having an institution go into receivership? Do you see the concern I have from a public policy perspective?

    Mr. GOLDSCHMID. I do, and that is why I stressed so heavily in my opening statement that we never want inadequate reserves. We allow for managerial judgment. We are not saying if you have a conservative reserve you ought to artificially drop it. That is a message we are sending time and again. Chairman Levitt made a speech on the 19th of May. He has repeated it in letters.
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    Mr. BAKER. I am only making the point we are sending that signal as hard as we humanly can.

    Mr. BAKER. Sending the signal, back to FASB, that the manipulation of the small loan loss reserve makes it very difficult to shield from a wary investor. You are going to look to capital adequacy. You are going to look to dividends. You are going to look at shareholder earnings, and if those things deteriorate, certainly the investor ought to be wary, but not if a loan loss reserve is dipped into on some regular basis.

    I am sorry, I have taken too much time.

    Mrs. KELLY. I appreciate your comments. I think the rest of us do also, Mr. Baker. If you have one more question, I mean if you have a question, there——

    Mr. BAKER. I have indulged the Chair too much. Thank you.

    Mrs. KELLY. Mr. Lucas, Mr. Goldschmid, thank you very much for being here, and I do want to remind you that you very well may see written questions from the subcommittee, and I thank you very much.

    Mr. GOLDSCHMID. We would be happy to have them, and I really do enjoy being before this subcommittee.

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    Mrs. KELLY. Thank you.

    We welcome the second panel. We appreciate all of your patience in being here today.

    On our second panel we have Federal banking regulators. Our first witness is Governor Laurence Meyer from the Board of Governors, Federal Reserve System. Governor Meyer has testified before the subcommittee several times this year, including, most recently, on May 12th on H.R. 1585, the Regulatory Burden Relief bill.

    Our second witness is FDIC Chairman, Donna Tanoue. Chairman Tanoue has testified before the subcommittee several times before also. As the deposit insurer, the FDIC has a unique perspective on banking issues. I look forward to hearing what the FDIC has to say about this very important safety and soundness issue.

    Our third witness is Mr. Emory Rushton from the Office of the Comptroller of the Currency. Mr. Rushton is the Senior Deputy Controller for Bank Supervision Policy. As we will hear, Mr. Rushton brings a wealth of real bank examination experience to the table. I believe this is Mr. Rushton's first time testifying before the subcommittee, and we welcome you, Mr. Rushton.

    Our fourth and final witness is Mr. Richard Riccobono from the Office of Thrift Supervision. Mr. Riccobono is the Deputy Director for the OTS, and this is also, I believe, Mr. Riccobono's first time testifying before the subcommittee. We welcome you also.

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    We have been called for a vote. I believe we should begin with Governor Meyer, and try to get through that testimony as quickly as possible, not because we don't want to hear, but because I believe we can then go for a vote and come back.


    Mr. MEYER. Thank you. Madam Chairwoman, Mr. Vento and Members of the subcommittee, I welcome the opportunity to discuss the Federal Reserve's views on recent developments relating to the allowance for loan losses. As a supervisor of banking organizations, the primary focus of the Federal Reserve is on promoting a safe and sound financial system. Conservative allowance levels contribute to safety and soundness by ensuring the depository institution maintains strong balance sheets and capital levels that reflect the collectability of the loan portfolio. Accordingly, the Federal Reserve and other banking agencies have long encouraged institutions to maintain strong loan loss allowances. As a reminder of the importance of conservative allowance levels, we need to look only to the recent experiences in certain foreign countries and the problems in the banking and thrift industries in the last decade.

    In the fall of 1998, the SEC announced an initiative to address earnings manipulation by registrants in a number of industries. Following the announcement of this initiative, the SEC raised concerns regarding the loan loss reserve practices of some banking organizations, requiring one banking organization to reduce its reserves by $100 million.

    The Federal banking agencies were concerned about these actions from a safety and soundness standpoint. The agencies' involvement led to an issuance of a November 1998 interagency statement which set forth the framework for the banking agencies and the SEC to begin working together on loan loss allowance issues.
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    The Federal banking agencies and the SEC issued another joint letter on March 10, 1999, reiterating the agencies' agreement to work together and announcing a number of joint efforts. The joint letter announced new initiatives of the agencies and the accounting profession to develop enhanced guidance on loan loss allowances over a one to two year period. In addition, the agencies stated that they would support and encourage the processes of the accounting standards-setters as they seek to clarify key loan loss allowance accounting issues.

    Most importantly, the letter indicated that the agencies will meet together periodically to discuss important matters that affect bank transparency and will focus on enhancing allowance practices going forward. The spirit of the March 10 joint letter was to put into place a process for resolving issues related to loan loss allowances going forward, and permit the agencies to work together in this process to resolve allowance matters and avoid significant changes in methodology that would encourage a decline in the allowances before this process had run its course.

    I might note that the March 10th joint agency letter was widely supported by the banking industry. Specifically, financial institutions and their auditors applauded the fact that the banking agencies and the SEC were committing to work together, and that the agencies' focus would be on enhancing allowance practices going forward.

    In April 1999, after a limited comment process that the banking agencies participated in, the FASB issued clarifying guidance, through an article in its Viewpoints publication, to banking organizations and other creditors on certain issues that arise in establishing loan loss allowances in accordance with GAAP. In response to questions received from accounting firms and creditors, the SEC announced on May 20th that registrants should follow the FASB guidance in developing their loan loss allowance estimates. Furthermore, registrants that would be materially affected by the FASB issuance were provided transition guidance by the SEC that should be implemented in the second quarter of 1999. At the same time, the SEC indicated that it had no view one way or the other with respect to the need for transition by institutions.
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    We understand that as they became aware of the planned announcement, many banks and auditors were confused as to its meaning in view of the joint initiatives discussed by the agencies in the March 10th interagency letter and the expectation that those initiatives would result in guidance being developed in the next two years. Moreover, some banks felt the implied message of this announcement was that their banks should reduce their allowance levels in the second quarter.

    The Federal Reserve was concerned that this uncertainty might result from an overreaction by the banking industry that could have reduced loan loss allowance levels in the second quarter contrary to our safety and soundness objectives. Given the possibility of an overreaction, the Federal Reserve issued a supervisory letter, SR 99–13, on May 21st interpreting these developments in the broader context of the initiatives announced on March 10th. We worked closely with the other Federal banking agencies and the SEC in developing this guidance.

    This guidance provided helpful background information to assist institutions and their auditors in understanding the SEC announcement and the FASB article in the broader context of other accounting initiatives under way. It also highlighted emerging points of agreement between the SEC and the Federal Reserve on allowance accounting matters. In this regard, the letter encouraged the banking industry to maintain conservative reserving practices consistent with management's best estimates.

    Furthermore, the guidance is intended to convey our understanding that the agreement reached on March 10th that maintains existing acceptable allowance practices during the period in which we are working to resolve allowance policy issues with the SEC and the accounting profession and develop additional guidance. Given the clarifying guidance and the supervisory letter and the work under way on important issues, we expect that changes in the allowance levels, if any, that result from the FASB guidance will be substantially limited.
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    The guidance included in this letter is consistent with GAAP. In this regard, the SEC staff has indicated that it very much supports the fundamental concepts in our letter, and the FASB and the SEC have included this Federal Reserve letter with the official GAAP guidance on loan loss allowances. Accordingly, based on assurances from the SEC staff, bank holding companies can follow this balanced guidance when reporting allowances in their published financial statements filed with the SEC. This should help reduce bankers' uncertainty and provide a calming message that reduces the possibility of an overaction by the banking industry and its auditors to the SEC announcement and the FASB article.

    Looking forward, we believe that it is very important that the agencies strengthen their commitment to the letter and spirit of the March 10th joint agreement, including the process for resolving issues related to allowance practices and the need to let this process run its course before significant changes, if any, are made to allowance levels.

    We believe that it is imperative that the banking agencies and the SEC develop this guidance in a collaborative manner and reach agreement about how this guidance is to be applied in practice. A collaborative approach is particularly important at both the principal and staff levels, because it will contribute to stability in the banking industry practices. In contrast, when communication breaks down regarding policy goals and implementing measures, either within an agency or between agencies, misunderstandings can abound. For example, the industry may be confused if it is perceived that any participant in an interagency discussion is communicating with banks and auditors in a manner that is not consistent with the spirit of the March 10th joint letter.

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    We also believe it is very important that any new guidance developed by the SEC and the banking agencies be well understood by the field staff, including agency staff members that have responsibility for assessing whether the allowance estimates of individual institutions are appropriate.

    Recent discussions between the principals and senior staff of the SEC and Federal Reserve Board and other banking agencies have been seeking to continue and enhance this collegial approach going forward.

    Under existing GAAP pronouncements, the allowance for loan losses includes probable losses that are inherent in the portfolio, but not future losses. As we look to the future accounting standards for loan loss allowances, we believe that an expected loss approach, taking a more prospective notion for the allowance, may enhance the quality of reserve estimates when compared to the inherent loss approach now promulgated in GAAP. This is more consistent with the evolving credit risk management techniques used by financial institutions.

    Going forward, the Federal Reserve will work with the other banking agencies and the accounting standards-setters to explore the appropriate basis for establishing loan loss allowances, including consideration of the expected loss approach in a manner consistent with important safety and soundness and transparency objectives.

    Mrs. KELLY. Thank you very much, Governor Meyer.

    The hearing is now adjourned pending the vote. I want to tell you to please stay around, because we will begin as soon as we have a quorum.
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    Mr. MEYER. I will have to be leaving at 2:00, just to let you know. A staff member will take over at that time.

    Mrs. KELLY. Governor Meyer, we hope we have you out of here by that time.


    Mrs. KELLY. I would like to reconvene the hearing, please. Thank you very much.

    Our second witness is the FDIC Chairman, Donna Tanoue. Chairman Tanoue, we appreciate your being here this morning. We are anxious to hear your testimony.


    Ms. TANOUE. Thank you. Good afternoon, Madam Chairwoman and Ranking Member Vento. I appreciate this opportunity to testify on behalf of the FDIC on the importance of establishing appropriate loan loss reserves by FDIC-insured institutions.

    As you know, we all have been engaged in an ongoing dialogue on this issue. The objective of the FDIC in this undertaking is to achieve transparency in financial statements and reported earnings, and prudence and conservatism in institutions' loan loss reserves, all consistent with safety and soundness.
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    The FDIC, primarily through our examination process, emphasizes the need for banks to maintain prudent and conservative loan loss allowances determined in accordance with GAAP. Establishing appropriate levels is an art, not a science. The banking agencies and the SEC all agree that the process for determining reserves must be based on a comprehensive, adequately documented and consistently applied analysis of the loan portfolio.

    So, where does the disagreement lie? The FASB recently published an article in Viewpoints on loan loss reserves. The FDIC is concerned that financial institutions might interpret this article in isolation from other guidance on loan loss reserves, and we are also concerned that institutions might view this guidance as a signal to make unwarranted reductions in their reserves that could threaten bank safety and soundness. It is our view that the Viewpoints article does not address comprehensively many key issues.

    We also are concerned that previous guidance on other aspects of the accounting for loan loss allowances should not now be ignored. In addition, the SEC and the banking agencies are in the process of developing further guidance on several significant loan loss accounting issues that are not addressed in the Viewpoints article.

    While these missing elements do not necessarily mean that the article's authors disagree with us on these points, the article did raise some question in the minds of bankers. Some bankers asked the FDIC how they should factor the guidance in the article into their existing methodologies. We told the bankers they should follow GAAP for both regulatory reporting and other financial reporting, and that institutions should evaluate the effect of the guidance in the article on their overall allowance practices and levels.
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    Despite the judgmental nature of the allowance estimation process, the process must not be used to manipulate earnings or to mislead the various users of financial statements and regulatory reports. Nevertheless, we have been concerned that the misinterpretation of the Viewpoints article could result in banks having the impression that they are to unnecessarily reduce their reserves in their second quarter financial statements.

    Given the importance of loan loss reserves to both bank safety and soundness and transparent financial reporting, we at the FDIC remain committed to continuing to work with the SEC and the other agencies on the projects announced in the March 10th Joint Interagency Letter.

    In these projects, we plan to develop parallel guidance on the documentation that should support an institution's reported allowance and on enhanced public disclosures. The target date, as you know, for this guidance is March 2000.

    Madam Chairwoman and Ranking Member Vento, this hearing today provides us with an opportunity to provide further clarification on this very important issue. We believe that these hearings will provide valuable support as we work toward the completion of the projects announced in our March 10th Joint Interagency Letter.

    Thank you.

    Mrs. KELLY. Thank you very much, Chairman Tanoue.

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    Our third witness is Mr. Emory Rushton from the Office of the Comptroller of the Currency. Mr. Rushton, thank you.


    Mr. RUSHTON. Thank you, Madam Chairwoman and Members of the subcommittee. In addition to being Senior Deputy Comptroller for Bank Supervision Policy, I have also been a national bank examiner for the past 34 years, and I appreciate this opportunity to present the testimony of the OCC on the important issue of bank loan loss reserves.

    History has shown us repeatedly that loan losses are awfully hard to forecast before they become obvious, and bad loans have been the primary cause of almost all bank failures. Deficient reserves put an inappropriate burden on bank capital and increase the risk to the Federal Deposit Insurance Fund and, ultimately, the taxpayer. For that reason, it is critical that we closely scrutinize any action that could have the effect of causing banks to lower their reserves.

    We at the OCC do not believe there is a widespread problem with excessive bank loan loss reserves. Bank examiners, who are the best-positioned to know, have not reported such problems. Neither have the certified public accountants who review financial institutions' reserves and statements for compliance with GAAP. Moreover, we are especially concerned that this debate comes at a time when credit risk in the banking system is increasing.

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    The SEC's primary mandate of investor protection and the banking agencies' concern with safety and soundness are not in conflict or mutually exclusive. Indeed, conservative reserving practices that protect a bank's capital also protect its investors. The best antidote for concerns about the possible misuse of loan loss reserves is clear and consistent guidance by all the agencies on reserve process, documentation and disclosure.

    Loan loss reserves play a critical role in the health of the banking system. Simply stated, a bank's reserves should be management's best estimate of how much money the bank is going to lose on the loans it has made. A bank creates and replenishes its reserve by charging a loan loss provision expense against income and setting that money aside in a separate account on the bank's books. The reserve does not count as part of the bank's equity capital, and the bank may not use it for any purpose other than absorbing loan losses.

    When a loan goes bad, the bank deducts it from the reserve. At least quarterly, the bank has to reassess whether the amount remaining in its the reserve is adequate, given the amount of estimated losses left in the portfolio. Many factors play into that analysis, including economic trends and other environmental influences, and the whole process is highly subjective.

    Madam Chairwoman, it is fair to say the bank and thrift failures of the 1980's and early 1990's are still very fresh in the minds of most bankers, and as a result, most of them have tilted toward maintaining healthy reserves to provide a margin for error. Indeed, the bank regulators have consistently encouraged them to do so.

    For example, when I began my present assignment two years ago, one of the very first things I did was send a letter reminding bankers of the need to maintain capital and reserves commensurate with their risks. But this does not mean that banks should engage in pure speculation about future losses. Nor should they in any way manipulate their reserves to achieve some predetermined path for earnings or in any way deceive investors or regulators.
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    Because no banking activity is riskier than lending money, our examiners spend a major part of their time evaluating loans and the bank systems that produced those loans. These examiners are specially trained in credit analysis, and many of them have state-of-the-art skills in analyzing particular forms of lending. We also have a staff of Ph.D. Economists who back up our examiners with computer-based models designed to predict the risk of default and loss in loans.

    Our examiners are on-site full-time in the largest national banks, and at least once every twelve to eighteen months at smaller banks. While we are certainly interested in the bank's own analysis of its reserve and the work of its outside auditors, we do not rely on them to reach our conclusions. We independently test the adequacy of the bank's reserve ourselves. We dig into the loan files, analyze financial statements, check loan covenants and evaluate collateral. We also evaluate the bank's loan loss reserve methodologies and the quality of the documentation supporting it. If we find a bank to be significantly over- or under-reserved, or lacking proper documentation, then we carefully discuss that with the bank's management and board of directors, and we require corrective action.

    Based on these direct assessments, our opinion is that national banks as a group are not materially over- or under-reserved. That is why, again, we are so concerned about any action that might have the effect, albeit unintended, of applying general downward pressure on bank reserves.

    Madam Chairwoman, I have submitted a fuller statement for the record and will be pleased to respond to any questions you may have.
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    Mrs. KELLY. Thank you very much, Mr. Rushton.

    Mr. Riccobono, we would like it hear from you, too.


    Mr. RICCOBONO. Good afternoon, Congresswoman Kelly, Ranking Member Vento. Thank you for the opportunity to present the Office of Thrift Supervision's views on current guidance to financial institutions regarding allowances for loan losses and the generally accepted accounting principles.

    As you are aware—this was obvious from the first part of this hearing this morning—there is currently a fair amount of uncertainty among financial institutions about the expectations of banking and securities regulators regarding appropriate levels of loan loss reserves. At the heart of this debate is the need to ensure that financial institutions have adequately reserved for losses inherent in their loan portfolios, while at the same time address concerns that some institutions could use reserves to manage their earnings.

    Estimating loss reserves is, by its nature, subjective, requiring a high degree of management's judgment. Good judgment is important because if an institution reserves too low for its loan losses, it could later find itself in financial difficulty if it suffers much higher charge-offs.

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    If an institution overreserves for losses during a particular period, it is understating its earnings and possibly its true financial condition.

    In the former instance, concern exists for the financial stability of the institution and the Federal Deposit Insurance Fund. In the latter situation, shareholders and potential investors are not being provided fair financial information on which to base their financial decisions.

    We fully agree that institutions must not use reserves to manage earnings.

    OTS requires savings associations to follow GAAP when preparing their financial statements and quarterly reports submitted to the OTS. Institutions apply GAAP by reference to authoritative accounting pronouncements and predominant industry practice.

    With respect to the development of authoritative pronouncements by the FASB and the AICPA, OTS frequently comments on drafts of new accounting guidance that could have a significant impact on the thrift industry. Once finalized, this guidance is routinely disseminated to OTS examiners and they are provided training on the subject.

    As you are aware, we conduct frequent on-site examinations. Through many years of experience, we have found there is no substitute for on-site examinations to independently assess credit quality and the appropriateness of reserves. Evaluating the adequacy of allowances is a complex judgment that cannot be reduced to a formula based solely on historic charge-offs without consideration of other significant factors.

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    Exclusive reliance on historical charge-off information from prior financial reports is like driving in the rearview mirror. Historical charge-offs are a lagging indicator that may bear little relationship to losses inherent in the portfolio today.

    Institutions must maintain prudent and conservative, but not excessive, reserves that fall within an acceptable range of estimated losses. In determining the appropriate amount of reserves, institutions and OTS examiners consider a number of factors, including the institution's historic loss experience, portfolio composition, level of classified assets, quality of loan underwriting, adequacy of collateral, environmental conditions, and current economic trends.

    Also important is the experience of the institution's lending staff, its internal lending policies and procedures and the adequacy of its loan administration and collection functions.

    Recognizing the importance of ensuring that financial institutions are receiving clear signals on their appropriate level of loan loss reserves, we have been working earnestly with our sister banking agencies, the SEC and the accounting standards-setters toward a solution that we are hopeful will be implemented with minimal further disruption to the institutions we regulate.

    Pursuant to a March 10, 1999, letter issued by the banking agencies and the SEC, the agencies intend to work with the FASB and the AICPA over the next two years to provide additional guidance on loan loss reserve practices. We feel strongly that such guidance should support institutions' efforts to implement a reasonable, conservative reserving methodology in accordance with GAAP, that is well documented, fully disclosed in the financial statements, and consistently applied from one financial reporting period to the next.
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    The interagency process provides a forum to address some of the lingering issues that have arisen in recent years because of fundamental changes in credit risk management techniques used by financial institutions. In particular, current accounting practices may not accurately reflect the use of credit scoring and modeling techniques that forecast prospective losses.

    Based on information gathered through the working group, the accounting standards-setters, and the industry, the agencies will issue parallel guidance on appropriate methodologies, disclosures, and supporting documentation for loan loss reserves by March 2000. We urge that all participants respect the integrity of this process so that guidance can be developed based on an open, collegial and informed dialogue.

    Notwithstanding several intervening actions that may have sent conflicting signals to financial institutions, it is our hope that thrifts will not make fundamental changes to their reserve policies based on unclear guidance about what is and is not GAAP. The reason for formation of the joint interagency working group is for the agencies involved in this debate to share their experiences, and ultimately, to provide consistent guidance to financial institutions about the treatment of loan loss reserves under GAAP. We welcome the opportunity to address these issues with our fellow regulators.

    Thank you for your time, Congresswoman Kelly and Congressman Vento. I would be pleased to take questions.

    Mrs. KELLY. Thank you very much.
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    Thanks to all of you, the whole panel, I thank you all. I have a couple of questions that I would like to ask you to comment on.

    One is that the SEC states that it does not want financial institutions to artificially lower loan allowances or have inadequate allowances. The OCC, FDIC and OTS have indicated that their concern is that financial institutions interpret the FASB Viewpoints article as a signal to make unwarranted reductions in the loan loss reserves that could threaten bank safety and soundness.

    Why do you believe the banks would make unwarranted reductions based on this article?

    I would just like to start with Mr. Meyer.

    Mr. MEYER. We don't believe that banks should and we don't believe banks are going to make significant loan loss reserve reductions. Precisely to head off an overreaction to the FASB article and SEC announcement, we sent out specific guidance to our banks telling them that we believe that reserves should be conservative, that there should be a margin for imprecision, and that we didn't think that there was anything in the FASB article or SEC announcement that would warrant a reduction in loan loss reserve levels.

    Mrs. KELLY. Mr. Rushton.

    Mr. RUSHTON. We believe that the Viewpoints article, by the absence of any exposure for comment or distribution prior to publication, was written in such a way that lent itself to easy misinterpretation. We think the intent of the article was sound, but it could be very easily misinterpreted by many bankers as representing a departure from what is fairly standard industry practice with respect to reserving for expected future losses.
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    Mrs. KELLY. Mr. Riccobono.

    Mr. RICCOBONO. I think it was a combination of the two. It was the Viewpoints article, followed up with the transition period that was being offered, that made it confusing for financial institutions. Because if they took the Viewpoints article as simply the first step in this process of clarifying, and then immediately following that was the transition period announced by the SEC, that, I think, would create some confusion about whether they should or shouldn't be taking some action.

    Mrs. KELLY. Ms. Tanoue.

    Ms. TANOUE. I would echo the points made. The concern of the FDIC was that institutions might view the Viewpoints article in isolation, that they might not be looking at the fact that there is comprehensive and existing guidance already on the table, and the fact that the agencies have a four-part framework that we are looking at in terms of future guidance being developed, and that the Viewpoints article is only one leg of the four-part project.

    Mrs. KELLY. Ms. Tanoue, how many banks would you expect to have to make a transition adjustment to bring their loan loss reserves into an acceptable range based on what your interpretation would be of this FASB Viewpoints article?

    Ms. TANOUE. At this point in time, we believe very few institutions would have to make such an adjustment.
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    Mrs. KELLY. Do you think then they would be able to comply by that June 30th date?

    Ms. TANOUE. Unless they are absolutely not following GAAP at this time, we don't see why institutions might be making such adjustments.

    Mrs. KELLY. I would like to ask a question or two for Ms. Roukema. I would like to confirm that banking agencies currently require banks to follow the GAAP for loan loss reserves. I would like some confirmation about that.

    You are all nodding your heads.

    Mr. RUSHTON. Absolutely.

    Mr. RICCOBONO. Yes.

    Mrs. KELLY. Do you believe that the appropriate Federal banking agency should be contacted when the SEC is considering whether or not a financial institution's reserve for loan losses is in conformance with GAAP?

    Mr. MEYER. I would argue, yes. If there is an action by the SEC which could threaten a significant change in practices on loan loss reserve levels, then the banking agency should be consulted in advance of that action.

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    Mrs. KELLY. Anyone else?

    Mr. RUSHTON. We agree with that. We would like to be consulted early enough in the process so that we can discuss the matter with the SEC prior to their decision on final action against the registrant.

    Mr. RICCOBONO. We are sometimes in possession—not sometimes; we are in possession of more information than the SEC.

    Ms. TANOUE. I would say that today's hearing underscores the importance of cooperation and communication among all the agencies.

    Mr. MEYER. Could I just say that based on conversations with the SEC, including last evening, I think we are very close to an agreement on this point. I don't think there is a substantial disagreement. The issue comes down to those nuances again: what do we mean by ''significant''?

    You heard in the testimony that they raised the point that they send out 100 to 150 letters a year to banks, many of which have to do with very, very small events; and how do you separate out those that are relatively minor issues from those that are so significant that they could lead to a material change in reserving levels? It is with respect to those that we certainly want to have some consultation.

    Mrs. KELLY. I guess it goes down to the old saying: ''The devil is in the details.'' Thank you very much.
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    Mr. Vento.

    Mr. VENTO. Thank you, Madam Chairwoman.

    On that point, Governor Meyer, if it is 150 and they are all different and they are on technical or other aspects, but if it is a common issue, for instance, if it is with regards to this recent guideline, that would be significant, wouldn't it?

    Mr. MEYER. I think that is right. Even if they are small individual banks, they affect a large number of banks. I think that is a perfect example of something that should come to our attention.

    Mr. VENTO. I think especially, because obviously there is this joint task force or working group—I don't know if I am suggesting it, at least with regards to the March 10th memorandum—and if I were participating in that group—and that group was formed to discuss this particular point, was it not?

    Mr. MEYER. Absolutely, to ensure coordination and cooperation through consultation.

    Mr. VENTO. But the issue is obviously the Federal Accounting Standards Board came forth with this Viewpoints article, and then immediately following that, the Securities and Exchange Commission, SEC, came forth with this guidance. In other words, it suggests that really they had no option but to accept this publicly approved Viewpoints article and implement it because that is part of the process in which they don't have any ability to condition or to pause in terms of that issue, that they wanted to issue it and get it out.
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    I think the interpretation I would make is that if I am working with this group over here and then they are going independently and doing this, it seems to me to compromise the cooperation, at least it seems to me I would be questioning, you know, if I had been co-opted. You apparently don't feel that way.

    Mr. MEYER. No, I feel that way completely. Absolutely. The point I would make is we have an excellent process in place. The participants in that have to make their practice conform to that process. I believe that in this case, the combination of the FASB Viewpoints article, but really reinforced by the SEC announcement, was not in fact consistent with that process.

    Mr. VENTO. Do we have a two-brain beast here, with one for the tail and one for the head? I don't know. Is that pretty consistent? I don't want to make a point of that.

    I see people nodding, but for the record you have to say, ''Yes.''

    Mr. Rushton.

    Mr. RUSHTON. Yes, sir.

    Mr. RICCOBONO. Yes.

    Ms. TANOUE. I affirm that also.
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    Mr. VENTO. You affirm that. It occurs to me from a layman's standpoint, if you have a loss, or if you are anticipating a loss and setting aside reserves, you also have to reduce your future income. If you say, I have losses, the issue really gets down to whether there is documentation for loan loss reserves, which of course is going to be put in place. The issue is, if you are going to have a loan loss reserve, that is the end result; that is not the first.

    First, you have to assume you are going to lose earnings, you are going to lose the corpus of that particular loan. Then you are going to have a loan loss reserve. So this is not a happy sort of circumstance. There is a certain symmetry here in terms of what happens; is that right, Mr. Rushton?

    Mr. RUSHTON. Yes, sir. There is a great deal of accounting symmetry here, prompted by a bank's own internal review of its credits from the standpoint of estimating which money will ultimately be lost and then creating the reserve based on that estimate. Of course, that is also reviewed by independent accountants, CPAs themselves, fully attuned to the GAAP requirements, and thirdly by our own examiners, who perform an independent assessment.

    Mr. VENTO. Well, I think, Chairwoman Tanoue—is there some track record of a problem here with overreserving or underreserving that is being missed by me?

    Ms. TANOUE. No. Based on our experience, we do not believe there is a problem of either overreserving or underreserving.
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    Mr. VENTO. And/or for problem loans. You start out looking at the loans, the quality.

    Mr. Rushton, you said, in fact, there are some credit quality questions with regards to existing portfolios. I think a function of the economy—do you want to articulate any further about that? Is that generally the experience of all of the regulators here?

    I see Mr. Meyer is nodding yes.

    Mr. MEYER. Yes.

    Mr. VENTO. Mr. Rushton.

    Mr. RUSHTON. We have been sending cautionary signals to the banking industry for the last couple of years about trends that we have detected, upticks in the severity of some of the problems we are seeing in new loan underwriting, delinquencies, nonperformance, high personal bankruptcy rates, and so forth, all of which contemplate a need for higher reserves rather than a reduction of reserves.

    Mr. VENTO. Thank you.

    Mr. Meyer, do you agree with that—Governor Meyer, pardon me?

    Mr. MEYER. Absolutely, yes.
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    Mr. VENTO. Governor Meyer, do you agree with this—you notice we were trying and, of course, Chairwoman Roukema put out some notification she wanted more time in order for this recent guidance to in fact be implemented an additional quarter. I don't know that that would work.

    Do you agree that in fact if there is—I think there is substantial concern. I mean, obviously the witness from the SEC, Mr. Goldschmid, didn't acknowledge that, but he said in fact he thought there would be very little problem.

    I think you think there is very little problem. But if there is substantial concern, do you think it would be a better policy, rather than having something that moves in fits and starts, to try to delay this for some time? There is no crisis right now, is there?

    Mr. MEYER. It would be our judgment that few banks would have to take advantage of it, and the particular date now is not an issue. However, if there was more concern and if there was a view in the industry that more banks would need to take advantage of that, then we would certainly have no objection to pushing that date backward. That would be reasonable.

    Mr. VENTO. You would in fact encourage that that would be more prudent, since there isn't a crisis?

    Mr. MEYER. Right.
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    Mr. VENTO. Do you have any comments, Mr. Rushton?

    Mr. RUSHTON. We believe an extension may unnecessarily elevate the significance of this announcement and cause some bankers to wonder whether there is more to this than they thought. We certainly don't want our bankers to make any dramatic adjustments to their reserves based on the Viewpoints article or the SEC's adoption of it. I think the industry is primarily concerned with the SEC's interpretation of the article and the plans that they may have in terms of implementing the article versus any real fear of what the article itself said.

    Mr. VENTO. Well, I know that from your statement, Chairwoman Tanoue, that you also agree with that, because of your answer to an earlier question.

    Mr. Riccobono.

    Mr. RICCOBONO. I would agree wholeheartedly.

    Mr. VENTO. I know that there are other questions that I should be asking, but I don't want to take all the time. Why don't you go ahead and ask your question?

    Mrs. KELLY. I do have one more question. I am throwing this out to the whole panel.

    The SEC obviously believes that some banks are way outside what is permitted by GAAP for loan loss reserves. How could accounting firms let this happen? Aren't the accounting firms exposed to huge securities law liability? I would like to hear from you about that.
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    Mr. MEYER. We don't believe that there is a problem with excessive loan loss reserves to begin with. In that case, we have no reason to believe that accounting firms are not doing their job well with respect to validating the processes that banks are following with respect to loan loss reserves.

    Mr. RUSHTON. We agree with that. We think the accounting industry, the banks themselves and certainly the regulators have been consistent in interpreting GAAP with respect to loan loss reserve for decades. We don't feel that the accounting industry is exposed on this at all.

    Mr. RICCOBONO. As you know from some of the testimony, we issued in 1993 interagency guidelines on this very subject. We sent it out for comment and received comment from both FASB and the SEC. That guidance has been the practice up until the fall of 1998.

    So I think, for the most part, accounting firms were following GAAP and the guidance we issued, which is in accordance with GAAP. So I think they believe, everyone at this point believed up until recently that what everybody was doing was in accordance with generally accepted accounting principles.

    Ms. TANOUE. I don't have anything to add to that.

    Mrs. KELLY. I thank you very much.

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    I just would then—just to understand this in my own mind, it appears to me that you differ with the SEC in their belief that some banks are outside the standard GAAP, what is permissible for loan loss reserves.

    Is that correct? Just yes or no.

    Mr. MEYER. No, I don't think there is any disagreement among the banking agencies in terms of whether there is a problem, in terms of what guidance banks should be following with respect to setting loan loss reserves.

    Mrs. KELLY. You don't agree with the SEC, or you do?

    Mr. MEYER. I don't think there is any disagreement. I think we don't think there is a problem right now with respect to excessive loan loss reserves, and I don't think we disagree on the guidance that banks should be following in setting those loan loss reserves.

    Mr. RUSHTON. We don't believe there is a systemic problem with excess reserves in the banking industry. That doesn't mean from time to time an individual bank may not get out of the ball park, and for those banks, hopefully the regulators and the SEC would come down on them.

    Mr. MEYER. We do not support banks having excessive reserves. They should be following GAAP, period.

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    Mrs. KELLY. All right. Thank you very much.

    Mr. Vento.

    Mr. VENTO. I think for some of the events that occur in the economy globally, and of course our banks, especially our large banks, are becoming more and more engaged and impacted, I would say, by such events; but loan loss reserves for changes—for instance, I notice in one testimony it was brought up, Brazil and Korea or something. So, I mean, loan loss reserves to address that and those kinds of events would very difficult, would they not?

    Mr. MEYER. That is why we say there is a margin of imprecision. When the banks follow a careful process of putting together those loan loss reserves, we do not tend to question their judgment if they decide that they need a conservative amount of reserves, given the conditions in the economy.

    Mr. VENTO. But Mr. Rushton, there is no cookie-cutter book out there. I can't go to a cookbook and select what I need to do in terms of loan loss reserves, can I?

    Mr. RUSHTON. No, sir.

    Mr. VENTO. That, in essence, is the problem, especially if I am a small bank and have a limited portfolio that may be concentrated in agriculture or has several loans that are very large, you may be more of an investor than a banker, I guess, in those circumstances. But there is no way that you can set aside enough for a loan loss reserve in those instances. The implication here, behind all of this, is that somehow there is going to be better documentation.
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    I know in informal conversations with—just during the interim, the hearing, that we talked about the fact that in fact there are new stress tests and other types of capital and loan loss reserve rules in fact being developed internationally.

    These have nothing to do with that. Is that correct?

    Mr. MEYER. Indeed one of the tasks of the AICPA Task Force is to see whether or not some of these new developments in bank risk management can be useful in the process and documentation and support of loan loss reserves. So I think this is quite relevant and one of the issues they are talking about.

    Mr. VENTO. Chairman Tanoue.

    Ms. TANOUE. I would just add, you were talking about some very difficult accounting concepts, and the agencies are in a great deal of agreement, and we are really working on a united front on the four projects that were identified in the March 10th letter. That work will be very important to providing further clarification and guidance for the future.

    Mr. VENTO. This is the second issue that we have had in recent years in this matter with regards to derivatives, now with loan loss reserves. I don't know, maybe we are talking about the same thing in terms of how we are going to require financial institutions to in fact document.

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    I understand that this loan loss reserve applies to both non-bank and bank, but specifically, this seems to me to be aimed at financial institutions.

    So the question is, and of course it is being raised in Congress, should Congress look to formalize or legislate a more formal process for the resolution of these matters so we can be certain as to the fact that there is a due process and procedure which is put in place?

    Mr. MEYER. I wouldn't think that any legislation is necessary. I think the banking agencies are working in a very cooperative spirit with the SEC and FASB, notwithstanding missteps and misperceptions that have been created in this process. But I think we do have a good process; we are working well together. I can't see an end that would be served by legislation at this point. That would be my judgment.

    Mr. VENTO. Does anyone else have any other comments about this procedure or process or the necessity to codify in Federal law?

    Mr. RUSHTON. The OCC would like to stress that the recent disagreement is not at all indicative of the prior relationship we have had with the SEC, FASB, or AICPA. We have decades of cooperative relationships with them. For instance, we provide documents and examiners as witnesses in the SEC's cases on a routine basis. This is an anomaly, and we think we can get over this.

    Mr. VENTO. Others?

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    Mr. Riccobono.

    Mr. RICCOBONO. With respect to the legislation, I think currently we have the right to be more stringent than GAAP. I think that goes a long way to giving us what we would need going forward with issues like derivatives, like gain-on-sale accounting and some of these other things that have come about.

    Mr. VENTO. Chairman Tanoue.

    Ms. TANOUE. I think you are hearing statements that underscore our renewed commitment to work together cooperatively.

    Mr. VENTO. Are any of you aware of any stock problems in terms of the marketplace reaction to an inappropriate statement of earnings on the part of financial institutions that has affected their stock or affected—added uncertainty to the true value, for instance, of a large or small institution?

    Mr. MEYER. No.

    Mr. VENTO. Well, I see everyone is answering in the negative, so I appreciate very much their presence. We will probably submit some questions in writing. Thank you for your presence this afternoon, for my part.

    Mrs. KELLY. I thank you very much, panel two, all of you for appearing and being so patient with our questions. I would like to go on to panel three.
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    I want to thank this panel for being so patient and waiting for so long. Our first witness is Mr. R. Harold Schroeder, of Keefe, Bruyette & Woods, Inc. Mr. Schroeder is a Senior Equity Analyst for Keith, Bruyette & Woods, which is nationally recognized as focusing on the financial services industry.

    In addition, Mr. Schroeder was a CPA with one of the major accounting firms for thirteen years and specialized in financial entities.

    Our second witness is Mr. Allen Sanborn, who is President and CEO of Robert Morris Associates. Mr. Sanborn was Vice Chairman of the Shawmut National Corporation from 1992 to 1995 and with Bank of America prior to 1992. Robert Morris Associates is the professional association for lending and credit risk professionals throughout North America and parts of Asia, representing some 3,000 institutions and 18,000 individuals.

    Our third witness is Mr. Rex Schuette on behalf of the American Bankers Association. Mr. Schuette is the Senior Vice President and Chief Accounting Officer for State Street Corporation in Boston, Massachusetts. In addition, Mr. Schuette is Chairman of the ABA's Accounting Committee.

    Our fourth and final witness is Mr. Martin Baumann on behalf of the Association of Independent Certified Public Accountants. Mr. Baumann, a CPA and partner with the accounting firm of Pricewaterhousecoopers, is the Chairman of the AICPA Task Force on Loan Loss Reserves.

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    We welcome you all and are anxious to hear your testimony. Thank you so much. Let us begin with Mr. Schroeder.


    Mr. SCHROEDER. Thank you. Madam Chairwoman and Members of the subcommittee, my name is R. Harold Schroeder. I am a Senior Equity Analyst in the research group at Keefe, Bruyette & Woods, a securities firm that is a nationally recognized authority on the financial services industry. Prior to becoming an analyst, I was a practicing CPA, auditing banks for a thirteen-year period that spanned the 1980's and early 1990's, a period of major changes and crises for the banking industry.

    I believe that my almost twenty years of combined experience as a CPA and securities analyst make me uniquely qualified to provide testimony on the issues outlined in a June 9th letter inviting me to testify. While I am well versed in accounting theory surrounding the issues being argued, the views I express today are not from the perspective of the Securities and Exchange Commission, the banks or the banking regulators, but from that of the ultimate users of financial statements, investors.

    In preparing my testimony, most institutional investors I spoke with sympathized with the SEC's concerns about earnings management and its corrosive effects on the integrity of financial reporting. In fact, when I first read the SEC chairman's September 1998 speech outlining his concerns on the topic, I too agreed in concept with most of his points.

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    But when it came to bank loan loss reserves, virtually all investors I spoke with were far less supportive. As one investor aptly put it, ''There is a direct link between a strong financial system and a strong economy.'' Adding, ''any actions by the SEC that could weaken a bank's resolve to maintain higher reserves would be like putting termites in the foundation.''

    Investors do not want accounting theory that results in an unwarranted reduction in loan loss reserves. It is not in their best interests. It is my view that if the SEC's interpretation of accounting rules is an inhibiting factor in maintaining adequate reserves, then the rules should be changed, not the reserves.

    Putting aside who may be right on accounting theory, we see no need for dramatic change in the way banks currently determine reserves or the level of current reserves. Investors are not being misled by current disclosures and they can readily see which banks are conservative versus those that are walking closer to the cliff's edge. In fact, investors are very attuned to when banks have used the loan loss reserve to manage earnings. So with investors not being misled, it seems unwise to push all banks to the cliff's edge with no room for error.

    Maintaining lower reserves is a particular concern, given the building market sentiment that credit quality is unlikely to get any better than it is today. Supporting these concerns are recent comments made by the President and CEO of the Federal Reserve Bank of New York. In responding to a question about credit quality, he voiced his view that banks don't make bad loans in the middle of a recession, banks make bad loans when the economy is strong. I agree with this view, and therefore find the timing of the SEC's quest for theoretical purity very puzzling.
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    What are the consequences of reducing loan loss reserves? Initially, because these reserves are simply another form of capital, the total stockholders' equity in banks will increase. This may sound good to investors and even some banks. Unfortunately, with more equity, banks may be tempted to increase dividends, buy back stock, or both. Such actions take capital out of the banking system and would put the system in a weaker position to withstand an economic downturn.

    To put this in context, I estimate that a 30 percent reduction in loan loss reserves would result in as much as a 3 to 5 percent reduction in capital for the banking industry as a whole. Of an even greater concern is in an economic downturn, banks would find it more difficult, if not impossible, to replace this lost capital. Unfortunately, even the mere threat of SEC action has moved banks away from erring on the conservative side and has increased the risk that some banks could ultimately find themselves under reserved for losses inherent in current loan portfolios. As a securities analyst, I have already heard from a few banks that are today citing the SEC's position as a reason for not fully replenishing reserves drawn down on loans as they are charged off.

    For the largest banks, our research shows the average reserve-to-loans ratio has dropped to 1.5 percent, a level not seen since 1985. More recently, this trend can be attributed at least partially to the SEC's pressure.

    Going forward, we expect loan loss reserves as a percentage of loans to continue to decline into 2000. This timing couldn't be worse. Short of repealing the credit cycle, most investors and analysts believe loan losses will likely increase, putting pressure on potentially weakened reserves.
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    It took years to rebuild public confidence in the U.S. banking system after the banking crisis of the 1980's and 1990's. I see tremendous risk in what the SEC is doing and little or no payback.

    Thank you.

    Mrs. KELLY. Thank you very much, Mr. Schroeder.

    Our second witness is Mr. Sanborn.


    Mr. SANBORN. Thank you, Congresswoman Kelly. Thanks for the opportunity to testify, number one, and I think holding this hearing is very, very critical. There is considerable confusion within the industry today over loan loss reserving.

    Unfortunately, the SEC appears to be changing long-standing loan loss reserve policies. The controversy centers on two issues, in my view: First, the continued use of managerial judgment. The second is continuing the reserve allowance for inherent or expected losses.

    I am Al Sanborn, President and CEO of RMA. It is a professional association of lending and credit risk professionals in the financial services industry. RMA represents approximately 90 percent of all loans in the banking system in the United States today. Our responsibility and our members' responsibility is to build processes to undertake, mitigate and control risks in the portfolio. A necessary outcome of that is setting an appropriate reserve.
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    There are 3,000 institutional members, 18,000 professionals. As hopefully a credibility statement, I was Vice Chair of two major financial institution holding companies in this country. I was a member of their highest-level committees, management, asset and liability and credit policy committees. I was actively and have been actively involved in the managing of portfolios and setting loan loss reserves for many years.

    I believe the confusion caused by the SEC's unilateral decision is bad public policy and could lead to some unfortunate negative outcomes for the U.S. economy, for the financial system, and for individual institutions.

    We are now in what can be called the ninth year of a normal seven year economic cycle. The SEC, by its actions, is suggesting that a number of banks are overreserved.

    As Members of this subcommittee well know, ten years ago the S&L industry was in great turmoil with significant costs to the American taxpayer. In the early 1990's, the Chairman of the FDIC came to Treasury and asked for a $25 billion line of credit to protect the FDIC fund.

    That never occurred, but you may recall, I think it was Congress had to set higher bank insurance fees to basically replenish the fund.

    The outcome, as we are all painfully aware, is the following: 1,200 community banks in this country disappeared and were closed by the regulators. That is 10 percent of all community banks in the United States. Eleven of the top fifty banks in the late 1980's in this country were forced into mergers.
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    I remind the subcommittee that the State of Texas, which now has the second largest population in this country, lost all of its large banks in this downturn. A very significant credit crunch followed the unexpected recession which economists tell us was quite mild by historic standards.

    Why did these events occur? One of the major reasons is that institutions did not have adequate loan loss reserves and other forms of capital.

    In my view, the banks and the banking regulators have made great progress in the 1990's to prevent these types of problems from occurring again. Today the application of modern portfolio theory better estimates expected losses in the portfolio. The banks have made tremendous investments in these programs.

    In addition, banks have built earnings power, capital levels and loan loss reserves.

    Why is the loan loss issue so important? Banks play a critical role in the economy by providing liquidity, particularly during difficult times not only on Wall Street, but equally important, on Main Street. We just have to remember, last fall, with the economic turmoil we had—the Russian bond default, the U.S. stock market dropping 20 percent, Long-Term Capital Management and its implications for the total financial system. Wall Street froze up—Wall Street was not taking risks and investors were not taking risks.

    I had a telephone call from a reporter from a major financial periodical that said, ''Mr. Sanborn, we understand the Fed is going to reduce interest rates because there is a credit crunch.'' I knew my members better than that. There was no credit crunch. There was clearly a capital market crunch.
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    I think this is a critical issue that hasn't come up today yet. Because banks were well reserved and strongly capitalized, they continued to lend to both Main Street and to Wall Street during this very difficult period of time.

    If banks had been less accommodating because of lower reserves, the economy could have been negatively impacted and, indeed, slipped into a recession, as many feared. So there really are multiple downside risks to this reducing-of-reserve issue from my vantage point.

    From my experience, setting loan loss reserves is both a science and an art. Banks have spent much time, effort and money perfecting the sciences of models, historic data, and so forth. However, the art of loan loss reserving is still a good and thoughtful management judgment process.

    The SEC appears inclined to limit management judgment. By its actions, the SEC appears to think a large number of banks are overreserved and reserving is a very precise science. My fear is that instead of being approximately right, the SEC is pushing for something that could be precisely wrong, with major negative ramifications for the economy and the banking system when the next downturn occurs.

    Both the SEC and the Fed survey data show that banks have tightened underwriting standards in response to deteriorating credit. Bank regulators have repeatedly warned of a rising credit risk in the banking industry. The SEC is sending the wrong message at the wrong time.
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    A respected bank analyst, Carol Berger, recently said, ''I am not a believer in the theory that there aren't economic cycles anymore. The lower the loan loss reserves are at the start of the credit cycle, the end of the expansion, the worse the cycle. It creates the credit crunch, it makes the whole economic environment worse, not just earnings at banks, but their willingness to lend.''

    I and RMA members are very concerned about the SEC's recent actions and the resulting confusion within the industry. The banking system will be tested again. Any loan, once underwritten, is a potential loss. Banks must continue to maintain adequate reserves for inherent risks within their portfolios. This is only logical economic sense.

    Doing so properly requires a high degree of science, but also a significant level of management judgment. The SEC's recent actions have called into question long-standing bank practices. This unfortunate conflict must be resolved.

    It is not clear to me just what the SEC is trying to accomplish with its change in policy. Some have suggested that the SEC is attempting to push the industry to full mark-to-market accounting. If this is indeed the case, should we be discussing the real economic impact of adopting such policy?

    Mrs. KELLY. Mr. Sanborn, the red light has been on for some time. Have you finished?

    Mr. SANBORN. Thank you very much.
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    Mrs. KELLY. Thank you.

    The next witness is Mr. Schuette.


    Mr. SCHUETTE. Thank you, Madam Chairwoman. I am Rex Schuette. As you noted, I am testifying on behalf of the American Bankers Association.

    At its heart, the appropriate level of loan loss reserves is a safety and soundness issue. Madam Chairwoman, Congressman Vento and others on the subcommittee have not forgotten the important lessons learned during the savings and loan crisis. You have made that clear in numerous statements. Perhaps the most important lesson was that adequate capital and reserves were critical to weathering the economic storm. Being adequately reserved is vital.

    The SEC's recent activities, which began with comment letters and actions directed at specific banking institutions, has, unfortunately, caused confusion, turmoil and disruption throughout the industry. Their focus resolves around the question of whether reserves have been used to manage earnings.

    We believe firmly that adjustments to reserves should be driven by probable losses, taking into account all relevant information, and not to manage earnings. Bankers believe that their reserves are not excessive. Auditors and bank regulators agree that banks are following GAAP.
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    We believe that the SEC has inappropriately targeted loan loss reserves as an industry issue and has done so at the wrong time in the economic cycle. Their recent actions, whether intended or not, may lead to a widespread dilution of reserves. Although certain SEC statements indicate that they are not changing the rules, their actions have been interpreted as forcing change without due process.

    I would like to focus on three points. First, reserves are vital to bank safety and soundness, and flexibility and careful judgment are critical to setting reserves.

    Second, accurate and timely reporting reserves are important for customers, investors and regulators. Banks believe they are meeting this need under existing GAAP.

    Third, if the SEC believes a change in the rules is necessary, the process should involve all parties.

    First, reserves are vital to banks' safety and soundness: Provisioning for loan losses cannot be reduced to a simple mathematical formula. Both auditors and bank regulators provide guidance on the factors to be considered in setting reserves, two of which include judgment and economic conditions.

    Bank regulator guidance states that it is important to recognize that the related process, methodology and underlying assumptions require a substantial judgment, degree of judgment; and credit loss and recovery experience may significantly vary depending upon the business cycle.
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    Banks and bank regulators recognize that continued economic growth cannot be sustained forever and that a slowdown in the economic activity should be considered in evaluating the adequacy of reserves.

    Setting reserves is a dynamic process requiring constant monitoring and adjustment. Each institution tailors its reserve methodology to its size, portfolio composition, credit culture and operating environment. This flexibility for individual institutions allows reserves in the system to adjust quickly to changing economic conditions, thus maintaining the safety and soundness of the banking system.

    My second point is that accurate and timely reporting of loan losses is important. Although estimating loan losses is not an exact science, the methodologies that institutions use are well established and accepted among regulators, auditors and banking institutions. In the absence of detailed guidance under GAAP, a framework for determining loan loss reserves has evolved generally through regulatory guidance. Over the years it has worked well to fill the gaps between existing FASB standards and the level of detail needed to account for loan losses.

    The FASB Viewpoints article, along with the SEC announcement, only increased confusion about how to accurately report loan losses. Bankers want to know: Is there a problem with the current accounting? Does the SEC view the rules differently from bank regulators and industry? If so, what are the rules?

    My third point, that the clarification of the rules for reserving is necessary: The process should involve all parties.
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    In recent months, layer upon layer of differing opinions and documents have buried the industry in confusion. What is important at this point is how banks, auditors and regulators view the SEC's intent. If the SEC believes it has not provided new guidance and has, instead, simply addressed some outlying situations, then clarification is needed.

    One banker expressed concern that each new document may add new interpretation of accounting rules. His fear is, he who produces the last document sets GAAP. The regulators, auditors and banking industry need clarity about loan loss reserves for accurate reporting and not the level of confusion we have now.

    On the other hand, if the SEC believes that the rules need to be changed, then the March 10, 1999, joint agency agreement should be followed and the banking industry and the banking agencies should be allowed to participate.

    In conclusion, we believe it is important for this subcommittee to know that we appreciate the efforts of the SEC chief accountant to open up communications with us on this and other accounting issues. Although we might not always agree, discussions with him have had some positive results.

    Madam Chairwoman, thank you for your efforts to add clarity to this important issue.

    Mrs. KELLY. Thank you, Mr. Schuette.

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    Our final witness today is Mr. Baumann. Please go ahead.


    Mr. BAUMANN. Chairwoman Kelly, Mr. Vento, Members of the subcommittee, my name is Martin F. Baumann, and I am testifying today on behalf of the American Institute of Certified Public Accountants as Chair of the AICPA's Task Force on Accounting for Loan Losses. I am also a partner of PriceWaterhouseCoopers, a public accounting and consulting firm.

    My oral statement will cover principally the AICPA's role in the standard-setting process and how the AICPA's loan loss task force is responding to the challenge of improving the accounting for loan losses.

    The AICPA, through its Accounting Standards Executive Committee, or AcSEC, works with the FASB in a collaborative process based on common objectives to issue authoritative accounting guidance that supplements the guidance provided by the FASB. GAAP for loan losses is found in various FASB pronouncements and in the AICPA audit and accounting guide, banks and savings institutions. In addition, the banking regulators and the SEC have issued guidance on accounting for loan losses.

    Under GAAP, a loss should be recognized when both of the following conditions are met: Information available prior to the issuance of the financial statements indicates that it is probable that an asset had been impaired at the date of the financial statements; and the amount of the loss can be reasonably estimated.
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    The purpose of those conditions is to require accrual of losses when they are reasonably estimatable and relate to the current or to a prior period. Losses should not be accrued if it is not probable that an asset has been impaired, because those losses relate to a future period rather than a current or prior period. Attribution of a loss to events or activities of the current or prior periods is a significant element of GAAP.

    Once it has been determined that a loan loss should be recognized, the amount of the loss must be estimated. Accounting for loan losses is very judgmental and therefore subjective. First, judgments must be applied to determine whether particular micro- or macroeconomic events have caused a loss to occur on either an individual loan or in some group of loans.

    Second, even more complex judgments must be applied to calculate the amount of any such loss. The reasonableness of loan loss accounting relies heavily on the quality and thoroughness of an institution's loan loss evaluation and measurement process, the consistency with which those processes and procedures are applied, and the sufficiency of the related documentation in support of the allowance for loan losses.

    For anything other than the simplest situations, reasonable people could differ on whether an event has caused a loan loss to occur, or if they agree on that, could differ on the estimate of such loss.

    Banking regulatory agencies and the SEC have at various times expressed concern about the application of the accounting standards surrounding the accounting for loan losses. This concern existed at times when it was thought that allowances for loan losses were insufficient, as well as at times when it was thought that allowances for loan losses might be so large as to be unjustified.
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    In late 1998 and early 1999, AICPA representatives met at various times with representatives of the banking agencies, the FASB and the SEC, to discuss the role the AICPA could play to address the concerns being expressed by regulators and bankers about current accounting guidance in this area. As a result of those discussions, the AcSEC task force on accounting for loan losses was established in March 1999.

    The task force includes representatives from public accounting firms and the banking industry and a former U.S. General Accounting Office official. Representatives of the banking agencies, the FASB and the SEC are invited to participate as observers and actively participate in all task force meetings.

    The task force will explore the loan loss accounting issues, examine existing GAAP in order to identify aspects that may need clarification, and if appropriate, develop proposed guidance for consideration by AcSEC.

    The task force has observed that current guidance on accounting for loan losses appears to lack the degree of clarity and specificity that is needed to ensure that it is applied in a consistent manner. This lack of clarity and specificity in current guidance may result in differing views among preparers, auditors and regulators, which may, in turn, result in inconsistent financial reporting and may diminish the usefulness of financial reporting to use in financial statements.

    The task force has developed a draft prospectus for the project. The initial expectations stated in the prospectus are:
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    The task force will develop a statement of position which may, among other things, provide additional guidance and specific examples to help differentiate a current loss from a future loss;

    Clarify certain provisions of current GAAP; provide guidance on appropriate techniques and methodologies to measure loan losses;

    Clarify to what extent institutions should incorporate a margin for imprecision in their estimation of credit losses;

    Provide guidance on how current trends, future events and economic conditions should be considered in the measurements of loan losses;

    Consider the need for new or enhanced financial disclosure guidance; and

    Provide guidance on the documentation necessary for an institution to support its recorded allowance for loan losses.

    The timetable in the draft prospectus proposes that the prospectus will be cleared by the FASB in August 1999, that the task force will formulate its initial conclusions by the end of November 1999, and that a proposed statement would be issued for public comment in August 2000.

    This concludes my oral testimony. On behalf of the AICPA, I would like to thank you for the opportunity to appear here today and would be happy to answer any questions you may have.
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    Mrs. KELLY. Thank you very much, Mr. Baumann.

    We thank all of you for testifying.

    I have a couple of questions, and I know Mr. Vento does and probably Mr. Sherman. Welcome back.

    Mr. Schuette, in your testimony, you state that banks believe that they are meeting the need for accurate and timely reporting of loan loss reserves under existing GAAP that follow SEC and bank regulatory requirements. Bank auditors believe this, as well, or they would not have given their unqualified opinions of banks' financial statements.

    In view of this, it would not appear that many banks would make a transition adjustment, as discussed in the SEC guidance accompanying the FASB Viewpoints article; and I would kind of like your comment about that.

    Mr. SCHUETTE. I think at this time, Madam Chairwoman, we don't have all the facts as to how many banks would be, if they are going to require an adjustment in Q–2. I think the issue at hand we have looked at and had communication, limited in the process, was around the due process of providing input back on the Viewpoints article, and, additionally, that the Viewpoints article by FASB did not include a comprehensive review of the issues around FAS–5 as it relates in broader terms to the general unallocated reserves or judgment issues that are very important issues heard from the regulators and other people testifying today in determining the allocation for loan losses.
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    Mrs. KELLY. I appreciate that remark. Thank you very much. I have been trying to follow a path on that.

    I would like to ask Mr. Baumann a question for Ms. Roukema. The ABA states that there have been no independent audits of financial institutions by CPAs, resulting in an unqualified opinion, due to an excessive reserve for loan loss.

    Please explain your view of the recent interest by the SEC in potential earnings manipulation due to excessive reserves for loan losses.

    Mr. BAUMANN. I think that statement may be accurate, and whether or not there have been any qualified opinions surrounding bank accounts, there could be some somewhere. I don't know that.

    In general, banks and their independent accountants come to agreement with respect to this complex area of accounting for loan losses. A lot of time is spent on it in discussion, considering various economic factors and past history, and in discussion with the regulators as well. There is an agreement reached upon which, at the end of the day, the auditors can issue an unqualified opinion on the financial statements. With respect to that, agreement is reached in this complex area.

    I am sorry, the second part of your question was?

    Mrs. KELLY. The second part of her question was to please just explain your view of the recent interest by the SEC in the potential earnings manipulations.
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    Mr. BAUMANN. The SEC has had a concern about earnings management. We have not observed in our clients, in our firm, earnings management with respect to, certainly, this area, with respect to allowance for loan losses.

    Mrs. KELLY. Mr. Schroeder, have you observed any evidence of earnings manipulation as a result of financial institutions' arbitrarily increasing their reserves?

    Mr. SCHROEDER. Certainly not arbitrarily increasing the reserve.

    I think there is a broader question here: Have banks used the loan loss reserves to do any type of earnings management, either up or down? I would make a couple of observations.

    First, one of the first things investors ask us to look at is the bank matching provisions and charge-offs, current experience versus anticipated, and any difference between those two numbers is an indication of pulling earnings into the current period or pushing earnings out into future periods. It is something closely watched.

    So I don't think there has been any tremendous amount of earnings management, at least not in the banks we have followed.

    Mrs. KELLY. Thank you very much.
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    Mr. Sanborn, you testified that a policy of discouraging loan loss reserves could prove destabilizing to the long-term health of the industry and the economy as a whole. The SEC testified earlier they did not want nor have they ever wanted financial institutions to artificially lower loan allowances or ever have inadequate allowances. Would you comment on that?

    Mr. SANBORN. I think—we looked back historically, we went into the late 1980's, clearly there were some reserve issues. There were other issues, but there were reserve issues.

    My biggest concern is that this happened at what I would consider to be as almost a weird time in the sense that we had all this turmoil last fall with Russia, with Brazil, with the agricultural economy in this country, with energy. You name it, we had all these risks going up; and yet the SEC was coming after reserves.

    My view is that the reserves are a shock absorber that allows the banking system to move forward as best it can under difficult circumstances.

    The point I was trying to make is, if banks are underreserved, they tend to pull in their horns, and the economy needs the banks to be efficient in lending to good opportunities in difficult times.

    My concern would be kind of a long-term structural issue, if reserves were lowered, that in fact banks would feel less capable of continuing to lend in difficult times. Last fall was a very difficult time. Luckily it was very short, and the Fed moved very quickly. But if it had been prolonged, if could have been much more of a problem.
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    I don't know if I answered your question, but that is the broader issue I was trying to raise.

    Mrs. KELLY. Thank you very much.

    Mr. Vento.

    Mr. VENTO. Thank you, Mr. Sanborn and Mr. Schroeder. I think the issue here, and I guess I could ask the—I could save some questions for the other witnesses, but we are hearing from the regulators here, and apparently they are now trying to suggest that this guidance is not as serious, it won't take, it is going to be minor modifications.

    But I mean, the fact is if it isn't going to do anything, why did they issue it?

    Mr. SCHROEDER. That is certainly the argument I would make. If they are not trying to change anything, why did this additional clarification, if you will, come out?

    Mr. VENTO. It seems like it is more confusion, based on that, than clarification.

    Mr. SCHROEDER. It certainly has been for the banks I have talked to. There has been a tremendous amount of confusion. I think that what gave it even greater credence is, if in fact there is no change, why are you providing a transition period?
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    Mr. VENTO. That is safe harbor, so to speak.

    Mr. SCHROEDER. Yes, I feel much safer now. It is really a very odd sequence of events.

    On top of this, you have to put this in the context of the SEC's actions against SunTrust, arguably one of the more conservatively run banks in the country; and certainly from a loan loss perspective, very conservative, but very well run. For SunTrust to become the poster child on this issue, raised everyone's attention.

    Mr. VENTO. You have to advise these banks on what to do.

    Mr. SANBORN. Certainly from my membership standpoint, this is a big issue. They wondered what the message is. You are a senior risk-taker.

    Mr. VENTO. They said they called up the chief accountant at the SEC and you could explain to her what your problem is, and apparently then you will get a ticket to do something else.

    Mr. SANBORN. Having been a banker, I will tell you, it is hard to come out publicly with——

    Mr. VENTO. That is sort of like going to confession if you are Catholic.
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    Mr. SANBORN. Remember the power they have. It is tough dealing with a regulator, and I understand the SEC is an enforcer in addition to a regulator. So, I mean, I have the same question. It is like the game of hide-and-seek, why ''all-e-all-e-outs-in-free'' at this point? If, in fact, they had expected reserves to be substantially increased because the industry was underreserved, I am sure the hit would not have been allowed against capital, it would have been an earnings thing.

    Mr. VENTO. I gave them the fact that there ought to be an accurate statement of earnings here. I don't expect any of us to disagree with that. But I especially appreciate Mr. Schuette's comment about, I hadn't read your testimony before, but you refer to it as sort of a cookbook or cookie-cutter formula. You referred to it as a mathematical model. I guess I should have thought of that.

    It is very subjective, isn't it, Mr. Schuette?

    Mr. SCHUETTE. Yes, it is subjective. That is a key part of the process of evaluating the adequacy of the allowance for loan loss. It is not a single number. It is not one item that you pick and that is the allowance number you have. It is based on a very detailed, sophisticated methodology that banks are using, that they have been doing for the past twenty years, and working with regulators to provide for an adequate reserve, not excessive reserve.

    Mr. VENTO. Am I missing something here? If I am going to invest as an investor in a bank or some other investment, and they tell me they have a larger loan loss reserve or an appropriate loan loss reserve, this is not exactly going to inspire a lot of confidence in me in terms of investing in this, whether it is an insurance company or bank or whoever it is.
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    Mr. SCHUETTE. I would agree with that inference.

    Mr. VENTO. So is the marketplace telling us something, Mr. Schroeder, with regards to this, that we don't want to invest in banks? Because of all of the investments we have out there, they represent a big problem because of the way they are handling this particular entry?

    Mr. SCHROEDER. I don't think investors are confused. I would disagree for a moment.

    The size of the loan loss reserve is only one factor that is considered in investing in a bank stock. Charge-off experience, the past experience of the bank, is also a major factor. Because one bank has a larger reserve than another does not make it either a good or bad investment. I think that is just one factor for consideration.

    Mr. VENTO. That doesn't immunize you from further evaluation with regards to other issues. A lot of banks today don't even hold loans. They don't hold the paper. They sell it and have other types of interests.

    Mr. SCHROEDER. Most banks do still hold some.

    Mr. VENTO. Not as much as they used to.

    Mr. Baumann, I didn't want to miss you. I understand the members of the AICPA task force reviewed the Viewpoints article and may have expressed the concerns to FASB and the SEC.
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    What kinds of concerns do members of your task force—did they raise, if any, and how does the Viewpoints article impact your work going forward?

    Mr. BAUMANN. We did review the Viewpoints article. We thought it was consistent with generally accepted accounting principles. We did not think it changed GAAP. As a result of that, we didn't necessarily see the need for the issuance of the article, especially in light of the March interagency agreement to work forward and let the task force and others work through its time.

    So it is not really having any impact on the task force. We are continuing to work ahead and deal with the issues I addressed in my written testimony and oral statement. I believe FASB had a good intent of trying to clarify rules in a situation where there apparently had been some confusion.

    Mr. VENTO. But it is a distraction from the major issue that needs to go forward, because as you talked about this task force, the goal is to put out in August of 2000 an accounting standard for comment dealing with this very topic; is that correct? Did I misunderstand it?

    Mr. BAUMANN. You didn't misunderstand it. We will be studying the various issues surrounding the accounting for loan losses over the next several months and submit those to the various authorities that will have to approve our recommendations; and it will be into the August 2000 period by the time we issue something, yes.

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    Mr. VENTO. Do you think this procedure for calling up the chief accountant at the SEC to explain your problem is a good one? The problem of why they can't comply with the guidance on an individual basis, on a case-by-case basis, in case you have any problem?

    Mr. BAUMANN. I think the banking regulators have observed they don't expect to see a lot of changes. I am not really aware of many changes I expect to occur in banks' reserves for loan losses as a result of this. I don't think they will get too many phone calls at the SEC.

    Mr. VENTO. If you can imagine, this is a pretty big fantasy, but if I were actually in charge of a bank and I had some concern about this, I probably wouldn't want to be calling this particular regulator to alert them to whatever trespasses I had made with regard to loan loss reserve or subjective judgments with regards to this.

    It is probably not a very likely scenario in any case, either run the bank or to, in fact, make this call. So that is not really very workable, is it?

    Mr. BAUMANN. No, it is not.

    Mr. VENTO. I have to go to another meeting, Madam Chairwoman, so I am going to excuse myself and let my able colleagues, Mr. Bentsen and Mr. Sherman, continue.

    Mrs. KELLY. Thank you very much, Mr. Vento.

    Mr. Sherman.
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    Mr. SHERMAN. Mr. Baumann, there are these various sources of generally accepted accounting principles, obviously, the FASB statement being the most definitive. As I understand it, there will be a statement of position that will be issued by the task force. What is the timeframe on that again?

    Mr. BAUMANN. Well, that is a proposal.

    First of all, the task force, the process is, the task force prepares a prospectus. I briefly described that in my testimony.

    Mr. SHERMAN. It doesn't give answers so much as identifies questions. Pro the prospectus, what is the timeframe on that?

    Mr. BAUMANN. The prospectus which has been sent to the Accounting Standards Executive Committee, is expected to be debated in the next month, and then go on to FASB for approval. If approved, we would go ahead and do our work and come up with our recommendations; and our timetable in the prospectus is that those recommendations would be completed around the end of 1999 into early 2000.

    Mr. SHERMAN. So by the end of 1999, will there be a document emerging from this process which has equal or greater dignity to the article published by the FASB staff?

    Mr. BAUMANN. No. Our process then would go back through the FASB, and the FASB would review that document and then issue it for exposure. It would be exposed to the public at large and there would be a hearing to debate our findings.
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    Mr. SHERMAN. In trying the kind of pecking order of accounting pronouncements, nothing equals or trumps a staff article by FASB staff, not unless you go all the way up to the exposure draft of the FASB itself?

    Mr. BAUMANN. Not exactly. What I said is, our prospectus won't trump the article. But the statement of position—when it was ultimately issued, the statement of position would be a higher level of GAAP than an article, yes.

    Mr. SHERMAN. The statement of position, the timeframe on that is, again——

    Mr. BAUMANN. That would be the August 2000 timeframe when we expect to issue that for exposure. I think someone earlier today said the timeframe of the task force to study the issues, to expose the issues appropriately to FASB and then to have it exposed to the public at large, banks and others, would be an eighteen month to two year process.

    Mr. SHERMAN. So the ''exposure draft'' and the ''statement of position'' are one and the same document?

    Mr. BAUMANN. They could be if in fact it was approved.

    Mr. SHERMAN. I was hoping the statement of position would come more quickly.

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    Mr. BAUMANN. The statement of position would be the final document after it was exposed for final comment.

    Mr. SHERMAN. So we are going to be drifting out there with no more compelling guidance than an article written by the FASB staff members?

    Mr. BAUMANN. I wouldn't say that.

    Mr. SHERMAN. We have FASB-5.

    Mr. BAUMANN. I feel there are accounting rules, and I feel banks follow those accounting rules, and I feel that auditors understand those rules and so do regulators and the SEC. They do need clarification, and that is what we are working on.

    Mr. SHERMAN. Well, clarity and specificity have not yet been achieved. I have discovered that today as I tried to find out how the existing rules are supposed to be applied. I believe it was you or one of the other panelists that said there had to be an event which caused a loan loss to occur, but of course, even in the absence of an event, if you have a large loan portfolio, you are going to have a reserve of a certain percentage of that portfolio, correct, allowance for doubt accounts?

    This is the same question I asked the first panel.

    Mr. BAUMANN. Yes, that percentage is premised on events.

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    Mr. SHERMAN. And if you were a new bank, you would still have that, because the banking industry has had events.

    Mr. BAUMANN. Then you would look at the experience of the industry and relate that to your own portfolio.

    Mr. SHERMAN. Let's say you had prepared financial statements going through the process of whether to issue them, and this was a 2 percent reserve against those loans that were fully performing, and then the economists from the bank come in with a new report saying, ''In our region and the industries we loan, we expect the next twelve months to be very bad months. In addition, we feel that the industries and the localities that we make loans in, they are very badly prepared for Y2K, so we expect, for these reasons, to need that 4 percent of our performing loans will ultimately not be repaid.'' At that point, do you stick with the 2 percent or go with the 4 percent?

    Mr. BAUMANN. Any hypothetical is difficult to answer in that regard, and I would particularly like to stay away from Y2K. But in general, if the economist of the bank came in and said, having studied their use regions and having studied various international markets, my view of events in those regions and markets indicates that there has been a downturn that has occurred in those markets, then that downturn could be reflected as an increase in the 2 percent in your example.

    If the economist said, ''I expect there might be a downturn next year, but there is no evidence to show it has occurred,'' then a bank would not appropriately reflect a prospect that a downturn could occur in the future.
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    Mr. SHERMAN. So if you get—and you have never seen this, but imagine some parallel universe where you get ten economists to agree that times are good in December 1999, that the unemployment rate is down, that factories are operating at full production throughout the relevant region to this bank's loans; but all ten economists agree, by July of the next year, it is going to be in the tank, and they say, it is because we notice this wage pressure and that downturn in the Japanese economy, which has not affected our region yet, but which will.

    Do you have to have the downturn begin, or do you just have to have the economists agree that facts have occurred which lead them to project such a downturn?

    Mr. BAUMANN. Well, in general, I think as long as there is an event that the economists and others can point to—and in your example, there have been events in the Japanese markets or other markets, and we think those would affect our regional economies as well—those events could be factored into the allowance for loan losses. Also, experience and history can be factored in.

    Banks have something called ''migration analyses'' and other analytical tools that have been referenced by this panel and others, and those sophisticated models are used, as well, to calculate the impact of events and how those might affect losses.

    Mrs. KELLY. Thank you very much, Mr. Sherman.

    Mr. SHERMAN. Could I ask one more question?

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    Mrs. KELLY. With Mr. Bentsen's permission.

    Mr. SHERMAN. Are the rules as they are being applied objective enough so that if we were to take two similar banks and switch managements so that the style of the management style of A or the prediction style of bank A was over at B, and they were both looking at the portfolios, and we switched auditors as well, would we get the same result?

    Mr. BAUMANN. That would be unlikely.

    Mr. SHERMAN. Would it be real close to the same result? Or it could diverge?

    Mr. BAUMANN. It would be unlikely that you get the same result. The rules are highly judgmental and subjective, and therefore, people would come to different estimates of loan losses, especially in complex portfolios, but they should come within a range of acceptability at both institutions, even after you switched management.

    Mrs. KELLY. Mr. Bentsen.

    Mr. BENTSEN. Let me apologize for not being here for your testimony.

    Is the SEC just being obstinate about this and trying to carve out their turf and second-guess the banking regulators in this? I still don't understand where being overly conservative in increasing your allowance for loan loss reserves is somehow detrimental to the market or a fraud on the market or potential fraud on the market.
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    I had a chance to at least scan Mr. Schroeder's testimony, and I think that is what you are saying in your testimony. You are not saying that, but you are saying this is not necessarily a negative market effect for investors; in fact, you may be asserting the contrary.

    Mr. SCHROEDER. Maybe you could restate your question.

    Mr. BENTSEN. Why is it bad for banks to—why is it bad for investors for banks to take a conservative approach to loan loss allowance?

    Mr. SCHROEDER. I don't think it is actually. In fact, in many ways I disagree with the accounting standards as they are written today. I think it inhibits banks from keeping as adequate reserves as they may otherwise. What I mean by that is, I think too many people are dancing around some of these accounting issues trying to justify one position or another.

    I think in many ways the accounting rules today limit the bank's ability to protect themselves for events that they know or believe will happen in the future. This brings up the whole issue of future losses and whether or not they should be included in loan loss reserves.

    Mr. BENTSEN. My prior experience is, to some extent, credit quality rules, which these are similar to—are not goals that you try to achieve, or thresholds, but they are ceilings to some extent.
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    I know in working with mortgage portfolios that your models determine a certain amount you set aside for loss recovery, and you met that, because that was the goal that you met. It wasn't a threshold, that is, 1 percent or 2 percent, but we are going to set aside 5 percent just because we are overly generous this week.

    Mr. SCHROEDER. We are trying to take a very subjective subject here and apply some very objective criteria. As I was listening to the testimony this morning, I harkened back to think about the IRS rules; and every year some newspaper takes ten tax preparers and says, ''Please apply these rules to this set of facts and come up with the answer.'' They all come up with different answers. There is a specific set of objective rules.

    Then try to envision what happens when you take ten accountants and apply the existing rules to a very subjective set of events, facts and circumstances. You get a fairly wide range of answers that eventually get pulled into a more narrow range, so the accountants can sign off on the opinions. It is a very complex issue. You are never going to get closure on this.

    I think the markets have done a much better job of assessing what the risk is out there.

    Mr. BENTSEN. I have a problem with the SEC's position that somehow, benignly, you are misjudging the market by having excessive loan loss reserves and when the business cycle turns down, you are worse prepared than you would be if you had narrow reserves, and you would uptick your reserves. It makes no sense to me at all.

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    Mr. Goldschmid really didn't answer, at least for my purposes, didn't answer that.

    Mr. SCHROEDER. You are incenting banks to take reserves down a little bit, move it over into capital, and as soon as investors or banks see more capital, they have a tendency to either issue higher dividends or buy back their stock.

    Either way, that is outflow of capital from the banking system. When you most need that capital in an economic downturn, it will be difficult to get it back.

    We experienced that in the 1980's, and I feel we are pushing ourselves to the lower end of what is reasonable under current accounting standards; and we could find ourselves two or three years in the future asking, ''Why did we do this?''

    Mr. BENTSEN. What is the market incentive for a public company to reduce its earnings by increasing its loan loss reserves? How does that help its stock price or somehow hurt investors, which is what I think the SEC alleges.

    The second part of that is, how could you manage earnings realistically, how could you manage earnings, such as using loan loss reserves that in good times you inflate and in bad times you deflate in order to artificially pump up your earnings when your portfolio is coming crashing down?

    I think that was the other thing Mr. Goldschmid was trying to assert. How could you do that, without outright fraud?
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    Mr. SCHROEDER. I think Mr. Sanborn earlier referred to it as a ''shock absorber.'' There is the ability to take in the reserves a little bit or boost the reserve up a little bit, depending on what is going on that particular quarter.

    What we are trying to do, though, is to take a very long time period. Remember, most assets of a bank are fairly long-lived. We are saying over an extended time period, we think here is the basic economic return, the losses or gains we are going to have from this long portfolio. We are taking very thin slivers, CAT scans almost, of this very long time period, and trying to make an estimate of what earnings are. It is a very complex set of facts.

    Anyone can second guess in a particular quarter how much we should have sliced off for losses in that particular quarter. But it is a guess, frankly. It is not until you pull back and look over a longer, extended time period.

    If you are, in effect, managing earnings, it will become very obvious over a longer time period, and the markets will ultimately either penalize or reward the bank, depending on what their assessment is. If they are constantly managing earnings through bringing down loan losses, that will be reflected in the stock price.

    Mr. SANBORN. I thought there was a third issue, a negative position management could take. We talked about if you moved it from reserves to capital, pay a dividend, buy back stock; the third is, you just make more risky loans. Therefore, because you are trying to build your ROE, I think that is an issue.

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    The other thing, it does surprise me in this discussion about how you manage this provision. I worked around a couple of portfolios that kind of blew up on us. What tends to happen is not only do you have very high losses when you start to have losses, but you also have to build your reserves too.

    So there is no way you are pulling back when you are having large losses. You are not actually reducing your loan loss or managing your earnings. It may happen at the end of the cycle when things really get good again that you are a bit overreserved because of the nature of cycles.

    But this issue that people are putting things in a cookie jar to use is not reality, at least the portfolios I managed. You not only have high losses, your whole portfolio gets much weaker, so you need even more reserves. You don't pull it back at that point in the cycle, if that answers your question.

    Mr. BENTSEN. I am sorry I missed AICPA's testimony, as well, and I didn't get a chance to read all 150 pages or whatever that you put here, but I will get right to it.

    Do you all take a position, and I know you have a working group and you have to take a neutral position, but from the accounting industry's and auditors' perspective, have you taken a position with respect to whether or not the SEC should back off of this transition on the FASB—on making the transition in accordance with the FASB article that came out?

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    Mr. BAUMANN. Well, our task force is not addressing the FASB Viewpoints article or the transition, but the accounting profession accepted them both, and I think it was mentioned earlier today, they were incorporated into the FASB's emerging issue task force record; and therefore it has been accepted by the accounting profession that this would be the transition adjustment—if some bank wants to make a change in its allowance for loan losses in this quarter, this is how they would account for it.

    Mr. BENTSEN. I will finish with this, on this transition, if a bank chooses not to exercise this option by the end of the second quarter, have they given up their option at that point in time, and until there is a change, are they subject to having to go back and make a full correction up to three years? Is this a one-time offer?

    Mr. BAUMANN. I don't know the answer to that question. I think it was addressed earlier. Someone from the SEC said they could come in and talk to the SEC if they needed more time. I think that was referenced earlier today by the General Counsel from the SEC.

    My main point, I guess, would be, we don't think we would expect—there hasn't been a change in GAAP as a result of the Viewpoints article, and at least with respect to the institutions I am familiar with, we wouldn't expect therefore to see a significant change.

    Mrs. KELLY. Mr. Bentsen, do you need additional time?

    Mr. BENTSEN. I am fine.

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    Mrs. KELLY. We thank all of you for being here today and being so patient and putting up with these long questions we have been asking you. It is an important issue, and it was important that we hear from all of you. Thank you so much for being here.

    The hearing is adjourned.

    [Whereupon, at 2:05 p.m., the hearing was adjourned.]