    Depository Institutions: Divergent Loan Loss Methods Undermine Usefulness
    of Financial Reports (Chapter Report, 10/31/94, GAO/AIMD-95-8).

    Loan loss reserves are major indicator of a depository institution's
    loss exposure from problem loans and are critical to understanding the
    entity's financial condition. From 1980 to 1992, about 2,700 federally
    insured institutions failed, at a substantial cost to taxpayers and the
    insurance funds. Loan losses were the major cause of many of these
    failures. Past GAO reports have shown that institutions have made
    inadequate estimates of loan losses prior to failure and that regulatory
    examiners have lacked a consistent framework to quantify loan portfolio
    risks and assess reserve adequacy. This report presents the results of
    GAO's review of the methods used by federally insured depository
    institutions to establish loss reserves for loans that are likely to be
    uncollectible. Neither authoritative accounting standards nor regulatory
    guidance provide sufficiently detailed direction to depository
    institutions for establishment of loan loss reserves. As a result,
    institutions used widely diverse methods that produced reserves that
    could not be meaningfully compared among such institutions and may not
    have reflected the true loss exposure in the institutions' loan
    portfolios.

    --------------------------- Indexing Terms -----------------------------

     REPORTNUM:  AIMD-95-8
         TITLE:  Depository Institutions: Divergent Loan Loss Methods
                 Undermine Usefulness of Financial Reports
          DATE:  10/31/94
       SUBJECT:  Bank management
                 Accounting procedures
                 Insured commercial banks
                 Banking regulation
                 Reporting requirements
                 Risk management
                 Lending institutions
                 Loan defaults
                 Losses
                 Bank reserves

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    Cover
    ================================================================ COVER

    Report to Congressional Committees

    October 1994

    DEPOSITORY INSTITUTIONS -
    DIVERGENT LOAN LOSS METHODS
    UNDERMINE USEFULNESS OF FINANCIAL
    REPORTS

    GAO/AIMD-95-8

    Loan Loss Methodologies

    Abbreviations
    =============================================================== ABBREV

      AcSEC - Accounting Standards Executive Committee
      AICPA - American Institute of Certified Public Accountants
      FDIC - Federal Deposit Insurance Corporation
      FRB - Federal Reserve Board
      FASB - Financial Accounting Standards Board
      GAAP - generally accepted accounting principles
      OCC - Office of the Comptroller of the Currency
      OTS - Office of Thrift Supervision
      SEC - Securities and Exchange Commission
      SFAS - statement of financial accounting standards
      SFAC - statement of financial accounting concepts

    Letter
    =============================================================== LETTER

    B-257381

    October 31, 1994

    The Honorable Donald W.  Riegle, Jr.
    Chairman
    The Honorable Alfonse M.  D'Amato
    Ranking Minority Member
    Committee on Banking, Housing, and
     Urban Affairs
    United States Senate

    The Honorable Henry B.  Gonzalez
    Chairman
    The Honorable Jim Leach
    Ranking Minority Member
    Committee on Banking, Finance and
     Urban Affairs
    House of Representatives

    As the largest single component of most depository institution's
    assets, loans represent a significant potential for loss.  Estimated
    losses on uncollectible loans are reflected in financial reports of
    the institutions in the form of loan loss reserves.  This report
    presents the results of our review of the methods used by federally
    insured depository institutions to establish loss reserves for loans
    which are likely to be uncollectible.  Neither authoritative
    accounting standards nor regulatory guidance provide sufficiently
    detailed direction to depository institutions for establishment of
    loan loss reserves.  As a result, institutions used widely diverse
    methods that produced reserves which could not be meaningfully
    compared among such institutions and may not have reflected the true
    loss exposure in the institutions' loan portfolios.

    We are sending copies of this report to the Secretary of the
    Treasury; Director, Office of Management and Budget; Chairman,
    Financial Accounting Standards Board; heads of federal regulatory
    agencies for banking and thrift institutions; and other interested
    parties.  Copies will be made available to others on request.

    Please call me at (202) 512-9406 if you or your offices have any
    questions.  Other major contributors to this report are listed in
    appendix VI.

    Robert W.  Gramling
    Director, Corporate Financial
     Audits

    EXECUTIVE SUMMARY
    ============================================================ Chapter 0

       PURPOSE
    ---------------------------------------------------------- Chapter 0:1

    Loan loss reserves are a major indicator of a depository
    institution's loss exposure from problem loans and are critical to
    understanding the entity's financial condition.  From 1980 to 1992,
    approximately 2,700 federally insured institutions failed, at a
    substantial cost to the insurance funds and taxpayers.  Loan losses
    were the major cause of many of these failures.  Previously issued
    GAO reports have shown that institutions have made inadequate
    estimates of loan losses prior to failure, and that regulatory
    examiners have lacked a consistent framework to quantify loan
    portfolio risks and assess reserve adequacy.

    In the last 2 years, the condition of the banking and thrift industry
    improved dramatically.  To determine current loan loss reserving
    practices, GAO conducted case studies of 12 institutions, each with
    assets over $1 billion.  GAO assessed the reliability and
    comparability of their loan loss reserves by focusing on the methods
    the institutions used to estimate loss exposure and make allocations
    to reserves.  GAO also focused on the adequacy of accounting
    standards and regulatory guidance for establishment of loan loss
    reserves.

       BACKGROUND
    ---------------------------------------------------------- Chapter 0:2

    Financial reports of depository institutions affect the decisions
    made by investors, creditors, depositors, regulators, and others who
    rely on the accuracy of the accounting information presented in the
    reports.  To be useful, the information must be accumulated and
    presented in accordance with accepted standards that are intended to
    ensure that reports are fairly stated and can be meaningfully
    compared among institutions.

    As the largest single component of most depository institutions'
    assets, loans represent a significant potential for loss.  Likely
    losses should be reflected in institutions' financial reports in the
    form of loan loss reserves.  The depository institution's management
    is responsible for establishing loan loss reserves in accordance with
    generally accepted accounting principles (GAAP) and regulatory
    guidance.  It does this by making periodic provisions or charges to
    operating expenses.  The reserves adjust the institution's loans
    receivable to reflect amounts that management estimates will not be
    recovered.  The loan loss reserve must be sufficient to cover both
    specifically identified loss exposures as well as other inherent loss
    exposures in the institution's portfolio which have not yet been
    specifically identified.

       RESULTS IN BRIEF
    ---------------------------------------------------------- Chapter 0:3

    Contrary to the recent past when GAO found problems with understated
    loan loss reserves, the case studies GAO conducted for this report
    generally showed that institutions maintained significant amounts of
    unsupported reserves.  Both situations are symptomatic of the lack of
    definitive guidance for establishing and maintaining appropriate
    levels of loan loss reserves.

    GAO found that significant portions of most of the 12 depository
    institutions' loan loss reserves were not justified by supporting
    analysis and were not comparable among the institutions.  The
    reserves were developed using reserving methods that varied greatly
    regarding (1) the use of individual loan assessment results, (2)
    determination and application of historical loss experience, and (3)
    the inclusion of supplemental reserves.  Most of the supplemental
    reserves were not clearly linked to likely losses.

    As a result, investors, creditors, depositors, regulators, or other
    financial report users would not be able to meaningfully compare the
    institutions' reserves in judging their adequacy and the quality of
    the institutions' loan portfolio.  Further, unjustified supplemental
    reserves can be used as cushions to absorb changes in the condition
    of the loan portfolio and thus to control reported earnings and
    capital.  Such practices mask an entity's true financial condition
    and can mislead investors and impede regulators' ability to protect
    the deposit insurance funds.

    Neither authoritative accounting standards nor regulatory guidance
    provide sufficiently detailed direction to depository institutions
    for establishment of loan loss reserves.  The lack of detailed
    authoritative and regulatory guidance provided excessive flexibility
    to institutions in establishing loss reserves.  Such flexibility
    resulted in the use of widely diverse reserving methods that produced
    reserves which could not be meaningfully compared and may not have
    reflected the true loss exposure in the institutions' loan
    portfolios.

       PRINCIPAL FINDINGS
    ---------------------------------------------------------- Chapter 0:4

          RESULTS OF INDIVIDUAL LOAN
          ASSESSMENTS OFTEN NOT USED
          TO ESTABLISH RESERVES
    -------------------------------------------------------- Chapter 0:4.1

    Specific assessment of the collectibility of individual loans is the
    most accurate means to identify and measure loss exposure for
    larger-balance impaired loans.  However, to establish reserves, most
    of the institutions regularly applied their own loss history or loss
    factors that closely resembled industry averages in lieu of or in
    addition to results of specific assessments of impaired loans.  These
    practices may have distorted the loss exposure in individual loans
    and established reserves that could not be meaningfully compared
    among institutions.

    For example, the loss exposure for one problem loan from an
    institution in the sample was $21.2 million based on an individual
    assessment of collateral value versus outstanding loan balance.  The
    institution used loss factors which were similar to industry averages
    to establish a reserve for this loan of $8.1 million.  GAO believes
    this $13.1 million difference represented a material understatement
    of the institution's loss exposure on this loan.  Applying the
    reserve approach of another institution in our sample to the same
    loan, however, would have resulted in a reserve of $23.6 million.
    The difference in reserve amounts of $15.5 million exemplifies the
    lack of comparability in reserve approaches for individual problem
    loans.

          HISTORICAL LOSS RATES
          DETERMINED AND APPLIED
          INCONSISTENTLY
    -------------------------------------------------------- Chapter 0:4.2

    Loss exposures on unimpaired and smaller-balance loans are generally
    best estimated on a group basis using historical loss experience from
    similar loan groups.  Most of the institutions used their own loss
    experience to establish a large portion of their reserves.  GAO found
    the methods used to determine historical loss rates from past
    experience varied markedly and resulted in incomparable reserves.
    Institutions used widely different time periods of past experience to
    develop historical loss rates.  In some cases, the time periods
    reflected only the institution's most recent experience, such as the
    last 12 months.  However, in other cases, time periods included
    several years of past experience, thus helping to mitigate the
    effects of a particularly good or bad year on the historical loss
    rates.  Further, some of the institutions applied historical loss
    rates so as to reflect losses expected over the lives of their
    current loan portfolios.  Others, however, applied rates to reflect
    losses expected only for the coming year.

    The 12 institutions in our sample used loss history to establish from
    about 11 percent to 87 percent of their total reserves.  Nine of the
    institutions relied on loss history to determine 40 percent or more
    of their reserves.  These large percentages of reserves based on
    historical loss rates, combined with the widely different methods
    used to determine and apply those rates, are likely to result in
    significant incomparabilities in reserves.  Such incomparability
    hampers financial report users' ability to assess the true financial
    condition and relative health of depository institutions.

          LARGE SUPPLEMENTAL RESERVES
          NOT ADEQUATELY JUSTIFIED
    -------------------------------------------------------- Chapter 0:4.3

    Most of the institutions' reserves included large supplemental
    reserves that generally were not clearly linked to an analysis of
    loss exposure or supported by evidence which showed that losses were
    likely and reasonably estimated.  Supplemental reserves comprised
    over 30 percent of the total loan loss reserves for 7 of the 12
    institutions reviewed.  For example, one institution in the sample
    continued to build its loan loss reserve for several quarters even
    though its detailed analysis of the loan portfolio indicated that it
    had sufficient reserves.  At the time of GAO's review, the
    institution's reserve was about $612 million over what was justified
    by its own portfolio analysis.  This amounted to 15 percent of
    capital and exceeded the previous year's earnings by over 80 percent.
    In some cases, supplemental reserves acted as cushions which could be
    used to absorb changes in the estimated loan loss exposure of the
    institution.  Such supplemental reserves could allow bank management
    to avoid recording loss provisions or recoveries to reflect these
    changes in loss exposure.

    Such use of unjustified supplemental reserves can conceal critical
    changes in the quality of an institution's loan portfolio and
    undermine the credibility of financial reports.  Further, the use of
    reserve cushions which have been built up over time to absorb
    subsequent loan quality deterioration could impede regulators'
    ability to identify, between examinations, a decline in the financial
    condition of an institution early enough to take timely corrective
    action.

          ACCOUNTING AND REGULATORY
          GUIDANCE FOR ESTABLISHMENT
          OF RESERVES IS INADEQUATE
    -------------------------------------------------------- Chapter 0:4.4

    Accounting standards and regulatory guidance for the establishment of
    loan loss reserves do not provide sufficient detail regarding the
    appropriateness of using loan loss history to establish reserves for
    large impaired loans, the development and application of historical
    loss factors, and the maintenance of supplemental reserves.  This has
    given institutions excessive flexibility in establishing loan loss
    reserves.  A recently issued accounting standard for impaired loans
    and a joint regulatory policy statement on loan loss reserves have
    provided some additional guidance, but do not resolve the problems
    GAO identified.

       RECOMMENDATIONS
    ---------------------------------------------------------- Chapter 0:5

    GAO recommends that the Financial Accounting Standards Board (FASB),
    in close consultation with the federal depository institution
    regulators, develop a comprehensive standard for establishment of
    loan loss reserves.  The standard should (1) require institutions to
    establish reserves for large impaired loans based on the results of
    individual loan assessments, (2) provide sufficiently detailed
    guidance for the use of loss history to estimate inherent losses
    existing in the portion of the portfolio which has not been
    specifically analyzed for impairment, and (3) require that all
    portions of the reserve, including any supplemental amounts, be
    directly linked to and justified by a comprehensive documented
    analysis of current loss exposure in the loan portfolio.

       AGENCY AND FASB COMMENTS
    ---------------------------------------------------------- Chapter 0:6

    Each of the four federal depository institution regulators and FASB
    provided written comments on a draft of this report.  These comments
    are presented and evaluated in chapter 2.  FDIC, FRB, and OTS
    indicated that recently issued accounting and regulatory guidance
    discussed in the report was generally sufficient to address GAO's
    concerns.  However, their responses to GAO's draft report contained
    key differences in their characterization of interagency and other
    regulatory guidance.  In addition, while FDIC, FRB, and OTS generally
    shared GAO's concerns about the need to adequately identify and
    measure loan losses, they expressed the belief that, from a
    regulatory perspective, it was beneficial for institutions to
    maintain supplemental reserves and, in some cases, add-on reserves
    for individually assessed impaired loans.

    OCC generally supported GAO's recommendation that FASB address
    deficiencies in GAAP for determination of loan loss reserves, but
    stated that it believes that the existing body of regulatory guidance
    provides an appropriate framework for banks to determine an adequate
    level of reserves and for examiners to evaluate the sufficiency of
    those reserves.  However, OCC generally referred to its own guidance,
    rather than the interagency guidance cited by the other regulators.
    OCC's views differed significantly from the other regulators in
    several areas, particularly with regard to supplemental reserves and
    the use of industry averages to establish reserves.

    FASB stated that it believes existing authoritative accounting
    guidance establishes clear and common objectives which can be applied
    to recognizing loan losses.  However, its response differed
    significantly from those of some of the regulators with regard to the
    objectives of establishing loan loss reserves.

    The differences between FASB and the regulators, and among the
    regulators themselves, reflect the potential for inconsistent
    interpretations of current accounting and regulatory standards and
    underscore the need for more definitive, comprehensive authoritative
    accounting guidance for the establishment of loan loss reserves.  In
    addition, the general support of FDIC, FRB, and OTS for reserving
    approaches that include supplemental and add-on reserves is further
    symptomatic of uncertainty over how to best identify and measure
    probable existing loan losses.  GAO believes that reserve shortfalls
    as well as excesses are likely to result from this uncertainty,
    because fluctuations in loan quality may not be effectively captured
    by the reserving methodologies currently used by institutions and
    examiners.  Further, GAO believes that if regulators want
    institutions to set aside cushions for future uncertainties, this
    could be accomplished through direct capital appropriations.  Such
    cushions, however, should not be established as part of the loan loss
    reserve.

    The findings in our report show that the objectives of loan loss
    reserves are not clear and are not uniformly applied in practice.
    Therefore, GAO believes it is incumbent on FASB to provide additional
    authoritative accounting guidance for loan loss reserves as
    recommended.  The draft of this report sent out for comment also
    included a recommendation to the regulators to implement the
    principles of GAO's recommendations to FASB if FASB did not act to
    adopt those recommendations.  After consideration of the differences
    in responses to the report among the regulators, including the
    differences in interpretations of existing joint regulatory guidance,
    GAO decided to delete the recommendation to the regulators in the
    final report.  However, GAO encourages the regulators to support FASB
    in its efforts to develop a comprehensive accounting standard for
    establishment of loan loss reserves.

    INTRODUCTION
    ============================================================ Chapter 1

    In the late 1980s, loan loss reserves established by depository
    institutions were criticized by regulators as being inadequate to
    cover losses from bad loans.  From 1980 to 1992, approximately 2,700
    federally insured depository institutions failed, at a substantial
    cost to the insurance funds and taxpayers.  Bad loans for
    agriculture, energy, less developed countries, and commercial real
    estate contributed to the large number of failures.  In 1992, the
    condition and performance of the nation's depository institutions
    improved substantially.  Commercial banks posted record earnings of
    $32 billion while savings institutions posted aggregate earnings of
    $6.7 billion, continuing a positive trend that began in 1991.  For
    1993, this improvement continued with commercial bank profits of
    $43.4 billion and savings institution profits of $7 billion.
    Recently, some depository institutions have been criticized by
    regulators for maintaining more reserves than they need.

       BACKGROUND
    ---------------------------------------------------------- Chapter 1:1

    The management of a depository institution establishes loan loss
    reserves through periodic provisions or charges to operating
    expenses.  When a provision for loan losses is recorded by
    management, loan loss reserves increase by a like amount.\1 Loan loss
    reserves adjust the institution's loans receivable to reflect amounts
    that management estimates will not be recovered.  When losses
    associated with loans or portions of loans are confirmed or
    determined to be certain, the loans or portions of loans are removed
    from the books of the institution by writing off the loan against the
    loan loss reserve.  This results in removing amounts from the reserve
    that are associated with the confirmed losses.

    Loan loss provisions and reserves are key indicators of loan quality
    that are included in the financial reports of depository
    institutions.  Depositors, investors, and other financial report
    users rely on these indicators to make decisions about the financial
    condition of the institution.  Regulators evaluate the adequacy of
    loan loss reserves during on-site, full scope, safety and soundness
    examinations.  These examinations are conducted periodically to
    identify problems early and control risk.  Regulators also monitor
    reserves through financial reports received between examinations to
    track institutions' financial condition and performance.  Because of
    their importance to various users of financial reports, loan loss
    provisions and reserves need to accurately reflect specifically
    identified loss exposures as well as other inherent loss exposures\2
    in the institution's loan portfolio.

    Authoritative accounting rules for financial reporting are primarily
    established by the Financial Accounting Standards Board (FASB).
    These accounting rules are referred to as generally accepted
    accounting principles (GAAP) and are promulgated through the issuance
    of statements of financial accounting standards (SFAS) by FASB.  The
    American Institute of Certified Public Accountants (AICPA), through
    its Accounting Standards Executive Committee (AcSEC), issues
    accounting guidance on issues not otherwise covered in authoritative
    literature.  The Securities and Exchange Commission (SEC) has
    statutory authority to set accounting principles, but as a matter of
    policy it generally relies on FASB and the AICPA to provide
    leadership in establishing and improving accounting principles.
    However, SEC frequently issues accounting and disclosure regulations
    to supplement guidance provided by FASB and the AICPA.

    We have previously reported the existence of significant problems in
    measuring and accounting for losses from problem loans and regulatory
    examinations of loan loss reserves.  In our study of 39 banks which
    failed without warning in 1988 and 1989, we found that asset
    valuations the Federal Deposit Insurance Corporation prepared after
    the banks failed increased their loss reserves from $2.1 billion to
    $9.4 billion.\3 Although we acknowledged that several factors
    contributed to this difference, such as deterioration in loan values
    subsequent to failure, we concluded that a significant portion of it
    was caused by institutions making inadequate estimates of loan losses
    prior to failure.

    In our assessment of regulatory examinations,\4 we found that the
    four federal financial institution regulators--the Office of the
    Comptroller of the Currency (OCC), the Federal Reserve Board (FRB),
    the Federal Deposit Insurance Corporation (FDIC), and the Office of
    Thrift Supervision (OTS)--did not have a uniform risk-based
    methodology to judge an institution's loan loss reserves.  Examiners
    lacked a consistent framework to quantify loan portfolio risks such
    as real estate exposure, unfavorable economic conditions, and
    deficient loan policies.  Methods for assessing loan loss reserves
    varied among the regulators and the lack of a generally accepted
    method made it difficult for the regulators to successfully challenge
    management's estimates when the examiners believed reserves were
    inadequate.

    --------------------
    \1 Reserve balances are also affected by charge-offs and recoveries.
    Therefore, while the provision increases the reserve by a like
    amount, the net change in the reserve balance depends on the amount
    of charge-offs (net of recoveries).  However, for purposes of this
    report, we focused our discussion and analysis on the relationship
    between the provision and reserve balances.

    \2 Inherent losses exist when events or conditions have occurred
    which will ultimately result in loan losses, but the losses are not
    yet apparent in individual loans.

    \3 Failed Banks:  Accounting and Auditing Reforms Urgently Needed
    (GAO/AFMD-91-43, April 22, 1991).

    \4 Bank and Thrift Regulation:  Improvements Needed in Examination
    Quality and Regulatory Structure (GAO/AFMD-93-15, February 16, 1993).

       OBJECTIVES, SCOPE, AND
       METHODOLOGY
    ---------------------------------------------------------- Chapter 1:2

    Our objectives were to determine whether

      loan loss reserve methodologies used by insured depository
         institutions resulted in reserve amounts that were justified by
         supporting analysis and comparable among institutions and

      accounting standards provided by FASB and regulatory guidance
         provided by OCC, FRB, FDIC, and OTS were sufficient to promote
         fair and consistent financial reporting of loan loss reserves
         among depository institutions.

    To determine whether loan loss reserve methodologies used by insured
    depository institutions resulted in reserve amounts that were
    justified by supporting analysis and comparable among institutions,
    we conducted case studies of 12 depository institutions, each with
    total assets over $1 billion, which we judgmentally selected.  They
    are referred to as Institutions A through L in this report.  To
    include a cross section of depository institutions, we selected
    institutions supervised by OCC, FRB, FDIC, and OTS\5 that were
    currently being examined or had been examined during the last 12
    months.  For geographic diversity, we selected institutions located
    in California, Maryland, New York, North Carolina, Texas, and
    Virginia.

    For each institution, we reviewed all major components of the loan
    loss reserve methodology, including individual loan assessments,
    analysis of historical experience, and other means used for reserve
    allocations.  In addition, we reviewed the institution's overall loan
    loss assessment, including the criteria and methods used to estimate
    losses for both commercial\6 and consumer\7 loans.  To accomplish our
    work, we reviewed examination working papers for loan loss reserves
    and the institution's loan loss reserve documents, when they were
    available.  We also conducted detailed interviews with the regulatory
    examiner-in-charge and/or management to discuss the institutions'
    loan loss reserving methodologies and the application of accounting
    rules and regulatory guidance.

    To determine whether accounting standards and regulatory guidance
    were sufficient to promote fair and consistent financial reporting,
    we reviewed all relevant accounting and regulatory guidance for
    establishing loan loss reserves.  This included SFAS No.  5,
    Accounting for Contingencies; SFAS No.  15, Accounting by Debtors and
    Creditors for Troubled Debt Restructurings; SFAS No.  114, Accounting
    by Creditors for Impairment of a Loan; AICPA audit and accounting
    guides for banks and savings institutions; OCC Banking Circular 201,
    Allowance for Loan and Lease Losses; FDIC May 1991 Policy Memorandum
    for Allowance for Loan and Lease Losses; examination manuals for each
    of the four federal regulators; and the Securities and Exchange
    Commission's Financial Reporting Release No.  28, Accounting for Loan
    Losses by Registrants Engaged in Lending Activities.

    Each of the four federal depository institution regulators and FASB
    provided written comments on a draft of this report.  These comments
    are presented and evaluated in chapter 2 and are reprinted in
    appendixes I through V.  Our work was performed between November 1992
    and March 1994 in accordance with generally accepted government
    auditing standards.

    --------------------
    \5 The 12 institutions included 5 national banks regulated by OCC, 3
    state chartered banks regulated by FDIC, 2 state chartered banks
    regulated by FRB, and 2 thrifts regulated by OTS.

    \6 For purposes of this report, commercial loans are loans made for
    business, commercial real estate, and other trade-related activities.
    They do not include loans for 1-4 family residential property,
    consumer installment loans, and other consumer-related financing.

    \7 For purposes of this report, consumer loans are defined as loans
    to individuals for residences, automobiles, household items, family
    needs, or other personal expenditures.

    LOAN LOSS RESERVES WERE
    INCOMPARABLE AND INCLUDED LARGE
    UNJUSTIFIED AMOUNTS
    ============================================================ Chapter 2

    The 12 depository institutions we reviewed used markedly different
    methods to establish their loan loss reserves, which resulted in
    incomparable reserves, and, in most cases, significant portions of
    their reserves were not justified by supporting analyses.  Most of
    the institutions based large amounts of their reserves on loss
    history.  Historical loss rates provide a valuable basis for
    estimating future losses and can be appropriately used to establish
    reserves for nonproblem loans and smaller-balance pools of loans.
    However, the methods used by the institutions to determine and apply
    historical loss experience did not consistently identify and measure
    loan loss exposure, which resulted in incomparable reserve amounts.
    In addition, historical loss rates were routinely applied to
    establish reserves for individual problem loans even though
    individual loan assessments provide the most accurate means to
    identify and measure loss exposure for such loans.  Finally, most of
    the institutions maintained large supplemental reserves which were
    not linked to quantitative analyses of loss exposure or other
    evidence that demonstrated that the amounts were needed to cover
    likely loan losses.

    Neither accounting standards nor regulatory guidance provided
    sufficiently detailed direction about how loan loss reserves should
    be established to ensure that reserves are clearly justified and
    comparable among institutions.  Given such flexibility, the
    institutions used widely diverse loan loss estimating methods that
    resulted in incommensurable reserves and also reserves that may not
    have reflected the true risk of loss in their loan portfolios.

    Loan loss reserves that cannot be compared or that misrepresent risks
    in loan portfolios impede investors, creditors, depositors,
    regulators, and other users of financial reports from understanding
    the true financial condition of depository institutions.  Such
    reserving practices also impede early warning of changes in an
    institution's financial condition and timely regulatory actions to
    protect the banking and savings and loan insurance funds.

       RELIABILITY AND COMPARABILITY
       ARE KEY ELEMENTS OF USEFUL
       FINANCIAL REPORTING
    ---------------------------------------------------------- Chapter 2:1

    The primary purpose of financial reporting is to provide information
    to report users which they can utilize in making investment, credit,
    and similar decisions.  Statement of Financial Accounting Concepts
    (SFAC) No.  2, Qualitative Characteristics of Accounting Information
    (FASB, May 1980), discusses criteria that are necessary for
    accounting information to be useful for making business and economic
    decisions.  Reliability and comparability are two of the major
    criteria discussed in the statement.

    SFAC No.  2 states that accounting information is reliable to the
    extent that users can depend on it to reflect the economic conditions
    or events that it purports to represent.  Reliability of accounting
    information stems from representational faithfulness and
    verifiability.  In other words, to be reliable, accounting
    information must be verifiable and directly related to the economic
    resources and obligations of the enterprise, as well as to
    transactions or events that change those resources or obligations.
    With regard to comparability, SFAC No.  2 states that information
    concerning an enterprise gains greatly in usefulness if it can be
    compared with similar information about other enterprises and with
    similar information for different periods of time or points in time
    for the same enterprise.  The significance of information, especially
    quantitative information, depends to a great degree on the user's
    ability to relate it to some benchmark.  One of the principal reasons
    for accounting standards is the desire for such benchmarks for
    purposes of making financial comparisons.

       LOAN LOSS RESERVES ARE A KEY
       FACTOR IN DETERMINING THE
       FINANCIAL CONDITION OF
       DEPOSITORY INSTITUTIONS
    ---------------------------------------------------------- Chapter 2:2

    Loans are the largest single component of most depository
    institutions' assets; therefore, loan loss reserves and related
    provisions are critical to understanding the financial condition of a
    depository institution, including identification of changes in its
    credit risks and exposures.  Provisions directly affect an
    institution's current earnings and represent the amount necessary to
    adjust the loan loss reserve to reflect estimated uncollectible loan
    balances outstanding.  In theory, as the risks and exposures from
    uncollectible amounts in the loan portfolio increase or decrease,
    this should be reflected by a corresponding increase or decrease in
    the provision and reserve.  Because of their importance as indicators
    of financial condition, loan loss provisions and reserves must
    reliably reflect estimated losses in the loan portfolios of
    institutions and be subject to meaningful comparison.

    The loan loss reserve must be sufficient to cover both specifically
    identified loss exposures as well as other inherent loss exposures in
    the institution's portfolio.  Therefore, an adequate reserve hinges
    on (1) timely identification and analysis of loss exposures on
    impaired\1 loans, and (2) analysis of loss exposures on unimpaired
    loans considering past trends and current conditions.  Loss exposures
    on larger balance impaired loans are generally best evaluated using
    individual loan assessments, which include detailed review of the
    financial condition of the borrower, loan payment history, fair
    value\2 of collateral, loan guarantees, and other relevant
    information.  In contrast, loss exposures on unimpaired loans and
    smaller-balance loans are generally best evaluated on a group basis
    by assessing historical loss experience for pools of loans with
    similar characteristics, adjusted for changes in economic and
    business conditions which affect the institution's lending
    operations.

    --------------------
    \1 According to SFAS No.  114, Accounting by Creditors for Impairment
    of a Loan, a loan is impaired when, based on current information and
    events, it is probable that a creditor will be unable to collect all
    amounts due according to the contractual terms of the loan agreement.

    \2 Fair value is the amount one can reasonably expect to receive in a
    current sale, not a forced or liquidation sale, from a willing buyer.

       RESULTS OF INDIVIDUAL
       ASSESSMENTS OFTEN NOT USED
    ---------------------------------------------------------- Chapter 2:3

    All 12 institutions regularly reviewed their commercial loans
    individually as part of assigning risk ratings or grades\3 for credit
    quality to these loans.  However, to establish reserves for
    commercial loans that were identified as problem loans through this
    process, most of them routinely reverted to loss history in lieu of
    using individual loan assessment results or to supplement the
    results.  We were not able to determine the percentage of the
    institutions' total reserves that were established using these
    approaches because the amounts could not be sufficiently segregated
    from other reserves based on historical losses, including reserves
    for pools of nonproblem loans.  However, based on our review of the
    institutions' policies, discussions with management or examiners, and
    review of samples of problem commercial loans, we found that
    historical losses were reverted to in lieu of or in addition to
    individual problem loan assessments in the following cases.

      Institutions D and E used average historical loss rates that
         closely resembled loss rates for the overall banking industry in
         place of individual loan assessments.\4 Institution D always
         used these rates to set reserves for problem commercial loans.
         Institution E used the loss rates only when they resulted in
         more reserves than the individual assessments.

      Institutions A, B, and H used their own historical loss rates to
         establish reserves for individually assessed loans when the
         rates resulted in more reserves than the individual assessments.

      Institution G used its own historical losses to establish reserves
         for individually assessed loans when no loss exposure was
         identified by the individual assessments.

      Institutions C, F, I, and K used detailed assessments to establish
         specific reserves for individual loans.  These institutions used
         their own loss history to establish additional reserves over and
         above reserves determined from the detailed assessments.\5 In at
         least one case, these additional amounts were intended to cover
         possible deterioration in the current fair value of the loan's
         collateral.

    Because individual loan assessments provide the most accurate means
    to identify and measure loss exposure for larger-balance impaired
    loans, the use of historical losses by the institutions in place of
    or in addition to individual assessments may have overstated or
    understated reserves for these loans and thus misrepresented the risk
    in their loan portfolios.

    For example, the collateral gap\6 for one problem commercial real
    estate loan we reviewed at Institution D was $21.2 million.  Because
    there was no evidence in the loan examination file we reviewed that
    other payment sources, such as loan guarantors, could be relied upon
    to cover this gap, we determined that the loss exposure for the loan
    was the full $21.2 million.  However, as shown in table 2.1, the
    reserve that was established by Institution D with loss rates that
    closely resembled industry averages was only $8.1 million.  We
    believe that this $13.1 million difference represented a material
    understatement of Institution D's loss exposure.

    Also, as shown in table 2.1, had this same loan been in the portfolio
    of Institution E, reserves would have likely covered most if not all
    of the $21.2 million deficiency.  This is because Institution E's
    policy was to reserve for the greater of estimated losses based on
    loss rates which closely resembled industry averages or individual
    loan assessments.  Institution F, under its policy, would have likely
    established reserves for the entire $21.2 million deficiency noted
    above plus an additional $2.4 million,\7

    based on its own loss history, to cover possible deterioration in
    collateral value.

                              Table 2.1

                 Reserving Methods Produce Different
                  Results for the Same Loss Exposure

                        (Dollars in millions)

                                            Reserve
                     Collat   Loan loss     excess/   Collateral
                       eral     reserve  (deficienc  gap covered
    Institution         gap  allocation          y)    (percent)
    ---------------  ------  ----------  ----------  -----------
    D                 $21.2        $8.1     ($13.1)           38
    E                 $21.2       $21.2          $0          100
    F                 $21.2       $23.6        $2.4          111
    ------------------------------------------------------------
    The use of historical industry loss rates, or even historical loss
    rates for the institution, in place of individual loan assessments
    can just as easily materially overstate loss exposure on an
    individual problem loan where the collateral value or other payment
    source sufficiently covers the outstanding loan balance.  For
    example, another commercial real estate loan we reviewed at
    Institution D had an outstanding balance of $21.5 million, and the
    appraised fair market value of the loan's collateral was $25 million.
    Notwithstanding the fact that the collateral adequately covered the
    loan balance, the institution reserved $4.3 million for this loan as
    a result of using loss rates which closely resembled industry loss
    rates.

    Historical losses based on industry averages or an institution's own
    past experience do not accurately reflect the specific borrower's
    current financial condition, ability to make timely loan payments in
    the future, the current fair value of loan collateral, or other
    payment sources.  As a result, the historical loss factor cannot
    identify potential loss in a specifically identified impaired loan as
    reliably as a detailed assessment.  The use of historical loss rates
    in place of individual loan assessment results or to supplement such
    results can produce unreliable reserves and misrepresent the level of
    losses present in individually assessed loans.

    --------------------
    \3 Financial institution personnel assign risk ratings or grades to
    loans to monitor exposure to risk.  Institutions use various rating
    ranges but all ranges typically include categories which coincide
    with the regulators' loan classifications of pass or unclassified,
    special mention, substandard, doubtful, and loss.  A pass or
    unclassified loan is considered of sufficient quality to preclude a
    special mention or an adverse rating.  Special mention loans have
    potential weaknesses, which may if not corrected, lead to inadequate
    protection of the institution at some future date.  Substandard loans
    are inadequately protected by the current sound worth and repayment
    ability of the obligor or by the pledged collateral, if any.
    Doubtful loans have all the weaknesses inherent in an asset
    classified substandard and whose collection or liquidation is highly
    questionable.  Loss loans are considered uncollectible and of such
    little value that their continuance as active assets is not
    warranted.

    \4 Management officials of Institutions D and E stated that the
    percentages were developed through management consensus or other
    analyses; however, there was no support for the loss percentages in
    either of the institutions' most recent analysis of reserves.  The
    regulatory examiners stated that the loss percentages were based on
    the regulator's examination "bench mark" or "rule of thumb"
    percentages.  These percentages were developed by the regulator from
    industry historical averages, with no adjustment for differences in
    loan policies, loan administration practices, portfolio composition,
    or economic conditions affecting individual institutions.

    \5 Institution I also compared its historical loss rates to minimum
    benchmark rates that were judgmentally selected by management and
    used the higher of the two rates to establish reserves.

    \6 The collateral gap is the difference between the outstanding loan
    balance and the current fair value of the loan's collateral.  It is
    the major indicator of loss exposure for problem commercial real
    estate loans.

    \7 The institution's historical loss factor of 12.5 percent would
    have likely been applied to the loan's collateral value of $19.2
    million to arrive at the $2.4 million additional reserve.

       INCONSISTENT METHODS USED TO
       CALCULATE HISTORICAL LOSS RATES
    ---------------------------------------------------------- Chapter 2:4

    Historical loss analysis can provide useful indications about how
    large groups of homogenous loans have performed in the past.  This
    type of analysis can be used as a basis to estimate inherent losses
    on nonproblem commercial loans, as long as the estimate is
    appropriately adjusted in a verifiable manner to reflect current
    characteristics of the loan portfolio.  Such analysis is also
    effective for estimating inherent losses in smaller, low-risk loans
    such as consumer loans.

    All of the institutions used historical losses to establish reserves
    for loans that were not individually assessed.  As previously
    discussed, most of the 12 institutions also used historical losses in
    some form to establish reserves for specifically identified problem
    loans even when individual loan assessments were performed.  Thus,
    significant amounts of the reserves of most of the institutions were
    based on historical losses.  However, because the methods used to
    determine and apply these historical losses varied widely the
    resultant reserve amounts were not comparable among the institutions.

    As shown in figure 2.1, the 12 institutions used loss history to
    establish from about 11 percent to 87 percent of their total loan
    loss reserves.\8 Nine of the institutions relied on loss history to
    determine 40 percent or more of their total reserves.

       Figure 2.1:  Percent of
       Reserves Based on Historical
       Losses

       (See figure in printed
       edition.)

    \a Institution G's reserves based on historical losses included
    management adjustments for economic conditions, regulatory
    examination results, and other supplemental factors, which we were
    unable to segregate.

    As shown in table 2.2, the major methods that were used by the
    institutions to determine historical loss rates ranged from a
    relatively simple approach which used actual losses for 1 year to a
    relatively complex method known as migration analysis.  Migration
    analysis is a process by which loans are tracked and recorded by the
    institution as they move through various risk grades until they are
    charged-off as losses.  Using migration analysis, an institution can
    estimate losses for the current year and subsequent years for loans
    in each loan grade.

                              Table 2.2

                Major Methods Used by Institutions to
                   Determine Historical Loss Rates

            Method of    Length of    Method of    Length of
    Instit  historical   time data    historical   time data
    ution   analysis     analyzed     analysis     analyzed
    ------  -----------  -----------  -----------  -------------
    A       Actual       1 year       Loss trends  3 years
            losses

    B       Migration    7 years      Delinquency  2 or 3 years
            analysis                  flow-        depending on
                                      through      loan type
                                      analysis\a

    C       Migration    10 years     Delinquency  2 to 4 years
            analysis                  flow-        based on
                                      through      management
                                      analysis     judgment

    D       Average      Not          Actual       3 months
            loss rate    applicable   losses
            for
            industry

    E       Average      Not          Loss trends  25 months to
            loss rate    applicable                4 years
            for                                    depending on
            industry                               loan type

    F       Average      3 years      Average      1 year
            losses                    losses

    G       Actual       20 months    Average      5 years
            losses                    losses

    H       Average      Midpoint of  Delinquency  8 or 12
            losses       1 year and   flow-        months
                         4 years\b    through      depending on
                                      analysis     loan type

    I       Migration    1 year       Average      3 years
            analysis                  losses

    J       Migration    4 years      Migration    4 or 6 years
            analysis                  analysis     depending on
                                                   loan type

    K       Average      5 years      Average      5 years
            losses                    losses

    L       Unable to    Unable to    Unable to    Unable to
            obtain\c     obtain       obtain       obtain
    ------------------------------------------------------------
    \a Delinquency flow-through analysis is a process by which loans are
    tracked and recorded by the institution as they move through various
    delinquency categories (based on number of days past due) until they
    are charged-off as losses.

    \b Institution H calculated two loss estimates by using the average
    losses from the previous year and 4 years.  The institution used the
    midpoint of these two loss estimates to determine historical losses
    for reserve purposes.

    \c Institution L's federal regulatory examiner did not know how the
    institution determined its loss history.  We requested this
    information from the institution's management but it declined our
    request.

    As noted in table 2.2, Institutions B, C, I, and J used migration
    analysis to derive historical loss factors for their commercial loan
    portfolios.\9 Most of the other institutions used either actual
    charge-offs over a relatively short time period or average annual
    charge-offs to compute historical loss rates.  Generally,
    institutions that use annual charge-offs to develop historical loss
    rates attempt to identify losses that are likely to be confirmed and
    charged-off over the coming year.  In contrast, institutions can use
    methods such as migration analysis to attempt to capture losses that
    will likely be confirmed and charged-off during the life of the loan
    portfolio.  Because commercial loans can have maturities beyond 1
    year, the loss rates developed using methods such as migration
    analysis will generally cover a longer period and, therefore, will be
    greater than rates based solely on annual charge-offs.

    The institutions also used markedly different time periods of past
    experience to determine historical loss rates.  As shown in table
    2.2, the institutions' historical bases ranged from 1 year to 10
    years for commercial loans and from 3 months to 6 years for consumer
    loans.  The objective of using longer time periods to determine
    historical loss rates is to preclude a particularly good or bad year
    from having an inordinate effect on the institution's current
    reserves.  Ideally, a sufficient number of years should be used so
    that historical loan performance can be gauged over the course of the
    institution's economic cycle.\10 However, the objective of using
    shorter time periods such as 1 year is typically to reflect only an
    institution's most recent loss experience.  Reserves based on several
    years' losses can be significantly different than reserves based on
    the most recent 12 months, which could be a particularly good or bad
    year.

    For example, for one institution we reviewed, the average charge-off
    rate was 1 percent of total loans from 1989 through 1992.  Had the
    reserves been based on this average, they would have amounted to
    about 13 percent of the institution's capital at the end of 1992.
    However, had the reserves been based on charge-offs for the most
    recent 12 months, which amounted to 2.6 percent of total loans during
    1992, the institution would have established reserves of about 33
    percent of 1992 capital.  Clearly, in this case, the use of the
    average charge-off rate would have resulted in significantly
    different loss estimates than use of the most recent charge-off rate.

    Finally, most of the institutions used their own loss history to
    develop historical loss rates.  However, as mentioned previously,
    Institutions D and E used rates that closely resembled industry
    averages to establish reserves.  The industry averages were developed
    by the institutions' federal regulator, with no adjustment for
    differences in loan policies, loan administration practices,
    portfolio composition, or economic conditions affecting individual
    institutions.

    Loss reserve methods that rely predominantly on standard industry
    loss percentages are likely to create misleading loan loss provisions
    and reserves because they do not consider the particular
    characteristics of the institution's loan portfolio.  In addition,
    the use of such percentages creates reserves that are not comparable
    to reserves of institutions which use their own loss experience to
    estimate losses.

    For example, Institution H's loan loss reserve for commercial loans,
    which was based largely on its own loss history, totaled
    approximately $708 million.  However, application of the loss rates
    used by Institution D to Institution H's commercial loan portfolio
    balances, would have increased its reserve for commercial loans to
    about $1,139 million, or by 61 percent.

    These inconsistencies in the application of historical loss
    experience to determine current reserve estimates resulted in wide
    disparities in reserves among institutions.  These disparities were
    exacerbated by the fact, as stated previously, that most of the
    institutions used historical loss experience as their primary means
    to estimate loan loss reserves.  The resultant incomparability in
    reserves can be a major impediment to financial report users, as it
    hampers their ability to assess the true financial condition and
    relative health of depository institutions.

    --------------------
    \8 We estimated the amount of each institution's loan loss reserve
    that was determined from loan loss history and other factors--such as
    current economic conditions--based on our review of institution
    documents, examination working papers, discussions with management,
    and/or interviews with examiners.  Our estimates for historically
    determined reserves reflect amounts that we could clearly link to
    historical loss rates.  In certain cases, historical loss rates were
    used to establish reserves for loans that were individually assessed.
    For individually assessed loans, we could not always segregate
    amounts based on loss history from amounts that were based on
    detailed individual loan assessments.  The reserve amounts shown in
    figure 2.1 could be even greater had we been able to segregate all
    amounts included in individual reserves which were based on
    historical factors.

    \9 Institutions B and C used migration analysis to track criticized
    loans, which include loans graded special mention, substandard,
    doubtful, and loss.  Institutions I and J used migration analysis to
    track all commercial loans.  According to officials at Institution B,
    plans are being made to expand the use of migration analysis to track
    all commercial loans.  Management officials at Institution I stated
    that they had just begun to use migration analysis and only had
    historical data for about 1 year.  They stated that plans are being
    made to expand the period of time used to conduct their migration
    analysis.

    \10 An institution's economic cycle is the time period that typically
    encompasses expansions and contractions in business activity for its
    major commercial customers.

       LARGE SUPPLEMENTAL RESERVES NOT
       ADEQUATELY JUSTIFIED
    ---------------------------------------------------------- Chapter 2:5

    Supplemental reserves are reserves established by management over and
    above amounts determined by analyses of individual loans and loss
    history.  Although supplemental reserves may be needed to cover
    specific loss exposure not identified by individual loan assessments
    and loss history, they can conceal the true condition of an
    institution's loan portfolio and distort its earnings and capital
    position if used inappropriately.  Further, unjustified supplemental
    reserves are not comparable to reserves that reflect only estimates
    of likely losses.

    As shown in figure 2.2, supplemental reserves comprised over 30
    percent of the total loan loss reserves for 7 of the 12 institutions
    we reviewed.

       Figure 2.2:  Percent of
       Reserves Comprised of
       Supplemental Reserves

       (See figure in printed
       edition.)

    \a Institution G's reserves included management adjustments for
    economic conditions, examination results, and other supplemental
    factors, which we were unable to segregate from reserves based on
    historical losses presented in figure 2.1.

    In most cases, the supplemental reserves were not quantitatively
    linked to an analysis of loan loss exposure nor was there adequate
    support to demonstrate that they were based on reasonable estimates
    of likely losses.  The rationale for supplemental reserves varied
    among institutions.  We were told by management or examiners that the
    supplemental reserves were intended to adjust loss history for
    current conditions, provide a cushion for future uncertainties, or
    appease regulators.  Regulatory examiners for two institutions told
    us that the supplemental reserves resulted, in part, from management
    not reducing reserve amounts recorded in the institutions' records to
    reflect the most recent estimates of loss exposure.  By categorizing
    the differences between current loss exposure estimates and their
    recorded reserves as supplemental reserves, these institutions
    avoided taking a negative loan loss provision.

    Although two institutions linked a portion of their supplemental
    reserves to specific portfolio risk analyses, the majority of
    supplemental reserves were not adequately linked to specific loss
    exposure.  Explanations provided by management or examiners for
    supplemental reserves generally did not demonstrate that the reserves
    were justifiable loan loss estimates.  Several examples of
    substantial supplemental reserves that were not adequately linked to
    loan portfolio risk and likely losses follow.

      Institution B built its supplemental reserve to about 40 percent of
         its total loan loss reserve after federal regulators directed it
         to increase its reserve after an examination in 1992.  In the
         third quarter of 1992, the institution's detailed analysis of
         loan losses indicated that it needed an additional $301 million
         in loss reserves.  However, the regulator required the
         institution to take a loss provision of $400 million and
         increase its loan loss reserve by a like amount.  According to a
         senior management official, although not justified by the
         institution's loan portfolio analysis, management agreed to take
         the additional $99 million provision to comply with the
         regulator's decision.  Even though the institution's detailed
         analysis of its loan portfolio in the 3 subsequent quarters
         indicated that it had sufficient loan loss reserves, it
         continued to charge earnings by taking additional provisions
         each period with the encouragement of the federal regulator.  At
         the end of the second quarter of 1993, the institution's reserve
         was about $612 million over what was justified by its own loan
         portfolio analysis.  This amounted to about 15 percent of
         capital and exceeded the previous year's earnings by over 80
         percent.

      Institution L's supplemental reserve comprised about 48 percent of
         its total loan loss reserve.  Documents prepared by the
         institution indicated that most of this reserve was considered
         to be excess.  The federal regulatory examiner for the
         institution told us that he believed the institution used the
         excess reserve as a plug or cushion for the difference between
         the reserve that was needed to cover estimated losses and the
         reserve recorded in its books.  Although the federal regulator
         did not criticize the level of the institution's reserve, the
         state regulator believed that it was too high.  According to the
         federal regulatory examiner, the institution was not directed to
         adjust its reserve but requested to adequately support all
         supplemental reserve components in the future.

      Institution H's supplemental reserve comprised about 44 percent of
         its total loan loss reserve.  This amounted to about 8 percent
         of its capital and 56 percent of its earnings.  Neither the
         institution nor the federal regulator demonstrated that the
         supplemental reserve was based on reasonable estimates of likely
         losses.  According to management officials, most of the
         supplemental reserve was established through management judgment
         and consensus and was intended to cover possible losses
         associated with anticipated bulk sales of some of the
         institution's bad loans, potential errors in loan grading,
         inexperience with acquired banks, and local and national
         economic conditions.  However, there was no linkage of these
         factors to reserve amounts in the analyses we reviewed.
         Further, factors used to set supplemental reserves for specific
         types of loans were not supported.  One official stated that the
         institution maintains a large supplemental reserve, in part, to
         "keep the regulators happy." He stated that regulatory examiners
         have relied on "rule of thumb" percentages to determine reserve
         adequacy and have been more comfortable when the institution
         maintains a large reserve.

      Institution E had a supplemental reserve that comprised about 32
         percent of its total loan loss reserve.  Management officials
         chose to keep the supplemental reserve at current high levels to
         protect the institution against credit concentrations and
         possible economic swings even though they had noted that each of
         the institution's loan quality indicators had improved.
         Management officials stated that the large supplemental reserve
         was added to the current loan loss estimate, in part, to make
         the estimate equal to the reserve recorded in the institution's
         records.  This enabled the institution to avoid adjusting the
         recorded reserve downward to reflect the current estimate of
         loss exposure.  The supplemental reserve amounted to about 73
         percent of earnings and 6 percent of capital.

          SUPPLEMENTAL RESERVES MAY
          CONCEAL CHANGES IN PORTFOLIO
          CONDITION
    -------------------------------------------------------- Chapter 2:5.1

    Large supplemental reserves can mask changes in an institution's loan
    portfolio that are critical to understanding its financial condition.
    Previously established supplemental reserves can be used to absorb
    current increases in estimated losses.  In such instances, an
    institution can avoid increasing its current loan loss provision and
    reserve to reflect the deterioration in the portfolio.  In these
    cases, neither the institution's current loss provision nor changes
    in existing reserves would be reliable indicators of the increased
    risk in its loan portfolio.  Large supplemental reserves can also
    overstate risk by inappropriately hiding improvements in an
    institution's loan portfolio.

    Table 2.3 illustrates hypothetically how supplemental reserves can
    conceal current loan portfolio deterioration as well as improvement.

                              Table 2.3

                Examples of How Supplemental Reserves
                Can Conceal Changes in Loan Portfolio
                              Condition

                               1       2       3       4       5
    --------------------  ------  ------  ------  ------  ------
    Loan loss estimate    $1,800  $1,600  $1,500  $2,200  $2,400
    Recorded reserves      2,000   2,100   2,200   2,300   2,400
    Provision needed       (200)   (500)   (700)   (100)       0
    Actual provision         100     100     100     100     100
    Supplement               300     600     800     200     100
    ------------------------------------------------------------
    As shown in table 2.3, by taking loan loss provisions during years
    when the recorded reserve is greater than estimated loss exposure,
    the institution can build a substantial unjustified supplemental
    reserve.  The build-up of the supplemental reserve not only masks the
    improvement in the condition of the loan portfolio during years 1
    through 3, but also enables the institution to conceal the
    significant increase in loss exposure which occurs during years 4 and
    5.  Loss exposure increases by 60 percent between years 3 and 5;
    however, the loan loss reserve increases by only about 9 percent.  As
    a result of the unjustified supplemental reserve, neither the
    institution's annual provisions nor changes in its recorded loan loss
    reserve balances reflect the significant changes which occur in the
    quality of its loan portfolio.

    In order for institutions' loan loss reserves and related provisions
    to provide reliable information about the quality of their loan
    portfolios, these loan quality indicators must coincide with the
    institutions' verifiable estimates of loss exposure.  The use of
    large unjustified reserves undermines the credibility of these
    important financial condition barometers.  As previously noted, 7 of
    the 12 institutions we reviewed had supplemental reserves which
    totaled at least 30 percent of their total reserves.  Conceivably,
    these institutions could use these reserves to absorb increases in
    estimated loan losses and not record loss provisions or adjust
    reserve levels to reflect changes in the condition of their
    portfolios for several periods.  Conversely, if their loan portfolios
    were improving and they continued to build supplemental reserves by
    maintaining the same levels of provisions and reserves as in prior
    periods, these loan quality indicators would not reflect this
    improvement.

    Some amount of supplemental reserve may be needed to cover specific
    loss exposure over and above that identified by analysis of
    individual loans and loss history.  However, an unjustified
    supplemental reserve can be used to manipulate earnings and capital
    position and, therefore, distort financial reports such that
    investors, creditors, depositors, regulators, and other report users
    do not have a clear basis for making decisions about the financial
    condition of an institution.  This lack of transparency is compounded
    when financial statement users attempt to compare institutions whose
    reserves are not comparable because they use significantly different
    approaches to establish reserves.  As a result, institutions that use
    unjustified supplemental reserves can seriously compromise both the
    reliability and comparability of financial information:  two key
    elements of useful financial reporting.

       AUTHORITATIVE GUIDANCE DOES NOT
       PROVIDE ADEQUATE STANDARDS FOR
       ESTABLISHMENT OF RESERVES
    ---------------------------------------------------------- Chapter 2:6

    Accounting and regulatory guidance for the establishment of loan loss
    reserves is too flexible to ensure reserves are determined in a
    consistent and reliable manner.  Only broad authoritative accounting
    standards exist for establishment of overall loss reserves, and they
    have been applied liberally in practice.  Regulatory guidance
    discusses the types of risks that need to be considered in setting
    reserves; however, the guidance does not provide sufficient
    information about how risks should be quantified and linked to
    reserve allocations.  Further, guidance provided by the four federal
    regulators is not always consistent.  The lack of adequate standards
    has resulted in reserve amounts which cannot be meaningfully compared
    among institutions and which may not represent the true level of risk
    in institutions' loan portfolios.

    The primary authoritative accounting literature governing
    establishment of overall loss reserves is SFAS No.  5, Accounting for
    Contingencies.  Although SFAS No.  5 states that provisions for
    losses should be made only when losses are probable and can be
    reasonably estimated, neither it nor any other authoritative
    accounting literature provides guidance or establishes parameters to
    ensure that loan loss history and other factors that are used to
    identify losses meet these two conditions.

    Recently, FASB issued SFAS No.  114, Accounting by Creditors for
    Impairment of a Loan.\11 SFAS No.  114 provides loss recognition and
    measurement criteria for individual loans that are identified for
    evaluation of collectibility.  The statement specifies that, for
    loans which are individually assessed, impairment should be measured
    on the basis of the present value of the loan's expected cash flows,
    the loan's observable market price, or the fair value of the
    collateral if the loan is collateral dependent.  SFAS No.  114,
    however, does not specify how a creditor should identify loans that
    are to be individually assessed for collectibility, address how an
    institution should determine loss reserves for loans that are not
    individually assessed, or provide additional guidance for the
    establishment of overall reserves.  Therefore, while SFAS No.  114
    provides specific guidance for determining when a loan has been
    impaired and how to quantify the impairment, it does not resolve the
    problems we identified in our review.

    Further, while the guidance in SFAS No.  114, if properly
    implemented, may be an improvement over current practice for
    assessing individual impaired loans, it will still lead to
    inconsistencies in establishing reserves, particularly for collateral
    dependent loans.  The three alternative approaches under the
    statement could result in very different loss estimates for the same
    loan because the fair value of the loan collateral could be quite
    different from the current market price of the loan.  The current
    market price, in turn, is also likely to be different from estimated
    discounted cash flows to be received from the borrower.  In addition,
    the timing of cash receipts may be difficult to predict.  In
    commenting on the Exposure Draft for SFAS No.  114, we advised FASB
    of our view that fair value accounting should be required for all
    collateralized problem loans, which would eliminate this
    inconsistency.  We believe that the fair value of collateral is the
    most objective and accurate measure to use to determine the loss
    exposure on a collateral dependent impaired loan.

    Regulatory guidelines developed by the four federal regulators are
    not consistent and generally lack specific direction for the
    establishment of overall loan loss reserves.  The guidelines for
    three of the regulators state that loan loss reserves must be
    adequate to absorb all estimated losses that meet SFAS No.  5's two
    conditions for loss recognition; however, one regulator's guidelines
    do not mention these criteria.  Regarding the use of loss history,
    none of the regulatory guidelines explain the merits and limitations
    of using migration analysis over other approaches to identify and
    measure losses that are probable and estimable.  Further, while the
    guidelines for two of the regulators do not address the number of
    years that should be included in determining historical losses, one
    regulator recommends 5 years and another requires 3 years.

    Regarding the way loss history should be applied to set reserves for
    loans, one regulator's guidelines clearly state that loans
    individually assessed should not receive reserve allocations based on
    loss history.  However, the guidelines for another regulator require
    institutions to add reserves to those determined from individual loan
    assessments.  A policy official for the regulator told us that
    institutions are required to add reserves for the fully
    collateralized portion of individually assessed problem loans.  Two
    regulators do not specifically address the application of historical
    information to individually assessed loans in their guidelines.

    Some of the requirements and suggested procedures in the regulators'
    guidelines promote the establishment of reserves over and above
    losses that are clearly probable and based on reasonable loss
    estimates.  Although each of the regulator's guidelines list a number
    of valid factors that an institution should consider in setting
    reserves, no discussion is included in any of the guidelines about
    how such factors should be assessed to ensure that all amounts
    allocated to the loan loss reserve are for likely losses and
    supported by verifiable analysis.  Further, one regulator's
    guidelines encourage institutions to use supplemental reserves to
    cover errors in the loss estimating process but do not provide
    parameters for establishment of such reserves.

    Management officials of three institutions told us that better
    guidance is needed for loan loss reserves.  Officials of the first
    institution stated that accounting and regulatory guidance is not
    helpful to institutions in setting reserves because they do not
    address how various subjective factors should be measured.  They also
    stated that there is too much variation in how reserves are
    established by institutions and that such variation needs to be
    addressed by accounting and regulatory guidance so that loss reserves
    are comparable among institutions.  Officials of the second
    institution stated that regulators and management are frustrated
    because there is no consistent approach to establishing loan loss
    reserves.  They stated that one regulator goes beyond GAAP by
    requiring the institution to set reserves for fully secured portions
    of loans.  A management official of the third institution stated that
    the guidance needs to include standards for the use of loss history
    so that institutions use a common basis for establishing loan loss
    reserves.

    The lack of accounting and regulatory standards for establishment of
    overall loan loss reserves has led to the evolution of a hodgepodge
    of accounting practices with no clear and common objectives.  Without
    adequate accounting and regulatory standards, management of
    depository institutions are afforded excessive flexibility in
    establishing loan loss reserves, and regulators may be prone toward
    arbitrary determinations of required reserve levels.

    --------------------
    \11 SFAS No.  114 applies to financial statements for fiscal years
    beginning after December 15, 1994.

          FEDERAL REGULATORS ISSUE
          INTERAGENCY POLICY STATEMENT
          FOR LOAN LOSS RESERVES
    -------------------------------------------------------- Chapter 2:6.1

    On December 21, 1993, OCC, FRB, FDIC, and OTS issued an interagency
    policy statement for loan loss reserves.  The statement supplements
    existing regulatory guidance and is intended to provide consistent
    approaches among the regulators to assess reserve adequacy.  The
    statement clearly states that an institution's reserves must be
    maintained at a level to absorb estimated losses that meet the loss
    criteria of GAAP.  Therefore, each of the regulators acknowledge that
    provisions and reserves must be adequate to cover losses that can be
    reasonably estimated and that will likely occur as stated in SFAS No.
    5.  The interagency statement, however, does not adequately address
    the problems we identified in our review--reserves not being
    comparable and possibly misrepresenting portfolio risk because of the
    use of loss history to supplement individual loan assessment results,
    inconsistent use of loan loss history, and unjustified supplemental
    reserves.

    According to the statement, the institution should rely primarily on
    an analysis of the various components of its portfolio to determine
    reserves, including analysis of all significant credits on an
    individual basis.  For individual loans, however, it does not
    prohibit or discourage institutions from using loss history to
    supplement reserves determined from specific detailed assessments.
    Further, it does not state whether institutions should reserve for
    portions of individual loans that are adequately covered by
    collateral.  As previously discussed, institutions' use of loss
    history in place of individual loan assessment results can
    significantly overstate or understate loss exposure for problem loans
    and produce reserves that are not comparable.

    Although the interagency statement states that losses should be
    estimated over the remaining effective lives of loans classified
    substandard and doubtful, it does not provide specific guidance or
    minimum requirements for the use of migration analysis or other
    techniques to ensure that losses are estimated in this manner.
    Rather, the statement states that methods for determining historical
    losses can range from a simple average over a relevant number of
    years to more complex techniques, such as migration analysis.  No
    discussion is included regarding what constitutes a relevant period
    of years for computing loss averages for loans or what must be done
    to ensure that all institutions consistently measure losses for the
    lives of their current loan portfolios.  As previously discussed,
    numerous inconsistencies in the determination of historical loss
    experience created disparities in reserves among institutions.

    Finally, according to the interagency statement, management's
    analysis of loan loss reserves should be conservative and include an
    "additional margin" so that overall reserves reflect the imprecision
    inherent in most estimates.  In addition, the statement lists
    numerous factors that management should consider that are likely to
    cause current estimated losses to differ from historical loss
    experience.  As previously discussed, most of the institutions'
    reserves were comprised of significantly large supplemental reserves
    which were not adequately justified.  This resulted in reserves which
    were not subject to meaningful comparison and which may have
    distorted the true condition of the institutions' loan portfolios.

    We believe the statement will encourage institutions to continue to
    use large unjustified supplemental reserves because it does not
    emphasize that inherent imprecision in loss estimates can result in
    overstatements as well as understatements of actual losses.  As a
    result, institutions will be encouraged to add to their estimates to
    cover potential error even if the estimates are too high.  Further,
    no discussion is included in the guidance to ensure that allocations
    to reserves are linked to the specified factors in a reasonable and
    verifiable manner and that the factors are used only to identify and
    measure likely losses.

       CONCLUSIONS
    ---------------------------------------------------------- Chapter 2:7

    Current loan loss reserve practices used by the 12 depository
    institutions we reviewed often did not result in meaningful
    assessments of the risk of loss due to uncollectible loan balances.
    In addition, the flexibility in accounting for loan loss reserves
    resulted in incomparability of reserves among the depository
    institutions and gave them the opportunity to use reserves to
    manipulate their operating results and capital.  While establishment
    of reserves will always require some degree of management judgment,
    it should not be an exercise in total management discretion, nor
    should it be subject to arbitrary regulatory adjustments.  However,
    until more specific standards are established by authoritative
    accounting bodies, incomparable and potentially unreliable reserves
    will continue to hamper the usefulness of financial reports of
    depository institutions.

       RECOMMENDATIONS
    ---------------------------------------------------------- Chapter 2:8

    We recommend that FASB, in close consultation with OCC, FRB, FDIC,
    and OTS, develop a comprehensive standard for establishment of loan
    loss reserves, which includes

      a requirement that reserves for all large impaired loans be based
         on detailed individual assessments, and no specific reserve
         amounts in excess of those determined from such assessments
         should be allowed for those loans.  For collateral dependent
         commercial loans, a reserve should be established to cover the
         difference between the outstanding loan balance and the
         estimated recoverable amount from the collateral based on an
         assessment of the collateral's fair value;

      guidance regarding the use of historical analyses to estimate
         inherent losses existing in the portion of the portfolio which
         has not been specifically analyzed for impairment.  Such
         guidance should address methods of analyses as well as the
         appropriate time periods of historical data to be included; and

      a requirement that all portions of the reserve, including any
         supplemental amounts, should be directly linked to and justified
         by a comprehensive documented analysis of current loss exposure
         in the loan portfolio and that the periodic provision for loan
         losses adjust the reserve balance to the level determined
         necessary by such an analysis.

       COMMENTS AND OUR EVALUATION
    ---------------------------------------------------------- Chapter 2:9

    Each of the four federal depository institution regulators and FASB
    commented on the report.  The regulators generally shared our
    concerns about the need to adequately identify and measure loan
    losses.  However, FDIC, FRB, and OTS indicated that, from a
    regulatory perspective, it was beneficial for institutions to
    maintain supplemental reserves and, in some cases, add-on reserves
    for individually assessed impaired loans.  In addition, they
    expressed their view that recently issued regulatory and accounting
    guidance discussed in the report are generally sufficient to address
    our concerns.  OCC generally supported our recommendation that FASB
    address deficiencies in GAAP for the determination of loan loss
    reserves, but stated it believes that the existing body of regulatory
    guidance provides an appropriate framework for banks to determine an
    adequate level of reserves and examiners to evaluate the sufficiency
    of those reserves.

    FASB disagreed with our conclusion that the lack of accounting and
    regulatory standards for establishment of loan loss reserves has led
    to the evolution of a hodgepodge of accounting practices with no
    clear and common objectives.  It stated that it believes that SFAS
    No.  5 establishes a broad set of clear and common objectives which
    can be applied to recognizing loan losses.  It also stated that if
    creditors ignore those objectives, "hodgepodge" accounting certainly
    could be the result.  However, FASB's response differed significantly
    from the responses of some of the regulators with regard to the
    objectives of establishing loan loss reserves.  Further, although the
    regulators' responses were often similar, we noted key differences in
    how they characterized various aspects of their interagency and other
    regulatory guidance.

    We believe that these differences between FASB and the regulators,
    and among the regulators themselves, reflect the potential for
    inconsistent interpretations of current accounting and regulatory
    standards and underscore the need for more definitive, comprehensive
    authoritative accounting guidance for the establishment of loan loss
    reserves.  In addition, we believe the general support of FDIC, FRB,
    and OTS for reserving approaches that include supplemental and add-on
    reserves is further symptomatic of uncertainty over how to best
    identify and measure probable existing loan losses.  We further
    believe that reserve shortfalls as well as excesses are likely to
    result from this uncertainty, since fluctuations in loan quality are
    not being effectively reflected by the reserving methodologies
    currently used by institutions and examiners.

    The draft of this report sent out for comment also included a
    recommendation to the regulators to implement the principles of our
    recommendations to FASB if FASB did not act to adopt those
    recommendations.  After consideration of the differences in responses
    to the report among the regulators, including the differences in
    interpretations of existing joint regulatory guidance, we decided to
    delete the recommendation to the regulators in the final report.
    However, we encourage the regulators to support FASB in its efforts
    to develop a comprehensive accounting standard for establishment of
    loan loss reserves.

    The following sections include summaries of the comments we received
    from FASB and the regulatory agencies on our conclusions and
    recommendations and our evaluation of those comments.  The written
    comments we received from FASB, FDIC, FRB, OCC, and OTS are reprinted
    in appendixes I through V, respectively.  Our comments on additional
    issues raised by the four regulators and FASB are also included in
    these appendixes.  It should be noted that, in the case of FASB,
    although our draft report was circulated to all Board members, its
    written comments do not represent FASB's official position.  The
    Board takes formal positions on accounting matters only after
    appropriate due process.  In that regard, FASB stated its Financial
    Accounting Standards Advisory Council would include the issues
    discussed in the report as a potential project in its 1994 survey
    questionnaire.

          COMMENTS ON INDIVIDUAL LOAN
          ASSESSMENTS
    -------------------------------------------------------- Chapter 2:9.1

    FASB and OCC generally agreed with our first recommendation that
    reserves for all large impaired loans should be based specifically on
    detailed individual loan assessments.  However, they also stated that
    review of loans with similar risk characteristics on an aggregated
    basis is acceptable.  FDIC and OTS agreed that significant impaired
    loans should be individually assessed and stated that such
    assessments are recommended by existing regulatory guidance.
    However, OTS also believed additional reserves over and above those
    based on individual assessments should be provided in some cases.
    FRB stated that basing reserves on individual loan assessments of
    large impaired loans was required under existing regulatory guidance
    and is standard banking practice, but also advocated consideration of
    standard industry loss percentages in establishing reserves for
    individual problem loans.

    In responding to our first recommendation, FASB indicated that SFAS
    No.  114, which applies to all large loans that are impaired,
    requires that impairment of those loans be measured on a loan-by-loan
    basis, unless the loans have common risk characteristics.  In that
    case, FASB stated SFAS No.  114 allows the use of aggregation
    techniques to measure impairment of loans with common risk
    characteristics.  FASB also indicated that if a creditor measures and
    recognizes impairment for a particular loan in accordance with SFAS
    No.  114 and SFAS No.  5, any additional loss recognition for that
    loan would not be appropriate.  Therefore, FASB stated it expects
    that many of the issues raised about individual measurement in the
    report will be resolved, or at least mitigated, when financial
    institutions adopt SFAS No.  114.

    OCC made similar comments with regard to aggregation techniques in
    responding to the first recommendation.  OCC generally agreed that
    banks should analyze all significant doubtful credits individually
    and attempt to estimate probable loss associated with each loan.
    However, it stated that as a practical matter, loan-by-loan estimates
    are not always possible, even for loans that are classified doubtful
    and especially for loans that are classified substandard.  Therefore,
    OCC believes that an estimate based on the bank's own historical loss
    experience on a pool of similar loans (adjusted for changes in
    conditions and trends) is an acceptable, and often more realistic,
    alternative.

    We agree that the type of aggregation techniques described by FASB
    and OCC can provide meaningful estimates of losses on impaired loans
    with similar risk characteristics.  However, the individual impaired
    loans we reviewed which were held by the institutions in our sample
    were large commercial real estate loans.  These loans generally have
    different types of collateral, borrower characteristics, loan terms,
    and geographic locations.  The loans we reviewed had all been
    assessed individually by the institutions and by the examiners for
    purposes of loan classifications, and in most cases sufficient
    information was available to estimate probable losses.  Nonetheless,
    many institutions reverted to establishing reserves based on loss
    history in lieu of or in addition to using the results of these
    individual assessments for large impaired loans.  The report includes
    examples of how these practices can distort the loss exposure in
    individual loans and resulted in reserves that could not be
    meaningfully compared among institutions.

    SFAS No.  114 does not specifically preclude institutions from using
    loss history factors to add on to reserves established based on
    individual loan assessments.  In addition, SFAS No.  114 does not
    specify how a creditor should identify loans to be evaluated for
    collectibility.  We believe this provides institutions with the
    flexibility to structure identification criteria such that certain
    impaired loans would be excluded, thereby allowing continued use of
    historical factors and other methods to set reserves for large
    impaired loans.  Therefore, we do not agree with FASB that SFAS No.
    114 resolves or mitigates the issues relative to individual loan
    assessments raised in the report.

    In its comments on our first recommendation, FDIC stated that the
    1993 Interagency Policy Statement, its own guidance, and SFAS No.
    114 already require institutions to assess all significant credits on
    an individual basis.  FDIC also stated that the Federal Financial
    Institutions Examination Council's (FFIEC) Request for Comment on
    Implementation Issues Arising From New Loan Impairment Accounting
    Rule, which was issued on May 13, 1994, states that the federal
    regulators do not plan to automatically require reserves over and
    above those established using SFAS No.  114 criteria.

    OTS made similar comments in response to our first recommendation,
    but also specifically stated it disagreed with the portion of the
    recommendation that indicates that no specific reserve amounts over
    and above those based on detailed individual assessments of large
    impaired loans should be allowed.  OTS stated that there may be
    losses inherent in any pool of assets, including pools of loans that
    have been individually assessed.  It went on to say that certain
    individually assessed loans still pose sufficient risk to an
    institution to warrant an additional reserve.  As a result, OTS
    believes it is appropriate to use both individual loan assessments
    and broader assessment techniques which incorporate risk factors that
    are not loan specific to establish reserves for large impaired loans.

    As discussed in the report, the 1993 Interagency Policy Statement
    referred to by FDIC and OTS does state that an institution should
    rely primarily on an analysis of the various components of its
    portfolio to establish reserves, including an analysis of all
    significant credits on an individual basis.  The statement also
    clearly states that an institution's reserves must be maintained at a
    level to absorb estimated losses that meet the loss criteria of GAAP.
    However, as discussed in the report, the statement does not prohibit
    or discourage institutions from using loss history to supplement
    reserves determined from specific detailed assessments.

    Additionally, while FFIEC's May 13, 1994, Request for Comment does
    state that the federal regulators do not plan to automatically
    require reserves over and above those established using SFAS No.  114
    criteria, it also states that an additional allowance on impaired
    loans may be necessary based on consideration of institution-specific
    factors, such as historical loss experience.  The implication of this
    statement appears to be that under certain circumstances it is
    appropriate for institutions to establish reserves for large impaired
    loans over and above what is determined necessary from detailed
    individual loan assessments.  OTS's comments indicate that it takes
    this viewpoint.  We believe this flexibility and inconsistency in
    regulatory policy will continue to promote inconsistent and, at
    times, inappropriate, reserving practices for large impaired loans.

    FRB stated that the approach we advocate with regard to large
    impaired loans has been general banking practice for many years and
    is consistent with SFAS No.  114.  FRB further stated that estimating
    the collectibility of large impaired loans on an individual basis is
    inherently judgmental and any single institution has limited
    historical experience with which to assess fully the many factors
    that affect the collectibility of an individual credit.  Thus,
    institutions and examiners should also consider the loss experiences
    of other lenders on similar problem loans.

    Our findings do not support FRB's contention that the use of
    individual loan assessments to set reserves for large impaired loans
    has been general banking practice for many years.  As stated in the
    report, most of the institutions in our sample reverted to loss
    history in lieu of using individual loan assessment results to
    establish reserves for problem commercial loans.  In addition, the
    two banks in our sample that were regulated by FRB used average
    historical loss factors which appeared to be based on industry
    averages as the basis to establish their reserves, including those
    for large impaired loans.  Individual loan assessments were performed
    on these loans, but were often used only to determine the loan
    classifications.  Standard percentages were then applied based on
    these classifications to establish the reserves.  As stated in the
    report, standard industry loss percentages do not consider the
    particular characteristics of the institution's loan portfolio.  We
    demonstrated in the report how the use of such industry averages can
    both understate and overstate reserves on large impaired loans.  In
    its comments, OCC agreed with our position on this issue.

          COMMENTS ON USE OF
          HISTORICAL ANALYSES
    -------------------------------------------------------- Chapter 2:9.2

    Regarding our second recommendation that guidance is needed for the
    use of historical analyses to estimate inherent losses existing in
    the portfolio, FDIC, FRB, and OTS all believed that the interagency
    policy statement provided adequate guidance on the use of historical
    loss experience.  However, their specific interpretation of that
    guidance varied, especially with regard to how industry averages for
    loss experience should be used.  OCC did not refer to the interagency
    policy statement, but indicated it believes that a bank's use of
    historical analyses should be based on its own experience, and not on
    industry averages.  FASB stated it believes that providing specific
    guidance in this area would impede the banks' ability to use the
    historical data that are most relevant to their particular situation.

    FDIC and FRB indicated that regulatory guidance provided in the
    interagency policy statement is generally sufficient with regard to
    the use of historical analyses to estimate loan losses.  They stated
    that the policy statement purposely does not provide specific,
    detailed guidance on the length of past experience that should be
    used by an institution or the methods that institutions should use to
    factor historical losses into their reserve estimates.  They believe
    differences among institutions in estimation methods are warranted
    based on differences in institution-specific factors and due to
    consideration of the benefits versus the costs of utilizing more
    complex, data-intensive approaches such as migration analysis.

    We recognize that institutions vary greatly in size and complexity
    and have different financial and technical resources.  Therefore, we
    believe it is important for standards and guidance to focus on
    alternative historical loss methods, including the time periods used
    to develop ratios or other historical data, so that probable losses
    that exist in similar loan portfolios of different institutions are
    identified and measured in a manner that produces comparable results.
    While the approaches used to accomplish this may be somewhat
    different, the basic parameters used should be the same, and
    therefore the results should be comparable.

    FRB also stated that while specific guidance to institutions on past
    loss experience is not provided in the policy statement, the
    statement does provide quantitative guidance based on industry loss
    experience that examiners should use to review the overall
    reasonableness of an institution's reserve estimates.  OTS made
    reference to this same guidance in the policy statement; however, it
    characterized it as specific guidance for the use of historical loss
    experience, including appropriate time periods.  It stated that the
    guidance provides that experience based on the institution's average
    annual rate of net charge-offs over the last 2 or 3 years for similar
    loans, adjusted for current conditions and trends, should be used.
    It also stated that industry-average net charge-off experience is
    appropriate only when the institution does not have a sufficient
    basis for determining this amount.

    The specific guidance in the interagency policy statement that OTS
    and FRB referred to is listed under the "Examiner Responsibilities"
    section of the statement as follows.

         "After analyzing an institution's policies, practices, and
         historical credit loss experience, the examiner should further
         check the reasonableness of management's (reserve) methodology
         by comparing the reported (reserve) against the following
         amounts:

         (a)50 percent of the portfolio that is classified doubtful;

         (b)15 percent of the portfolio that is classified substandard;
         and

         (c)for the portions of the portfolio that have not been
         classified, estimated credit losses over the upcoming 12 months
         given the facts and circumstances as of the valuation date."

    According to the policy statement, the first two factors in the above
    reasonableness formula are based entirely on industry averages.  The
    last factor is to be based on the institution's average annual rate
    of net charge-offs over the previous 2 or 3 years.  If this
    information is not available, then the examiner may use industry
    average net charge-off rates for nonclassified loans.

    Consistent with FRB's characterization, the policy statement says
    that the above formula is meant only as a reasonableness test to be
    applied by examiners.  We do not agree with OTS's statement that this
    formula provides specific guidance for the use of historical
    analyses.  In addition, we believe the use of this formula by
    examiners or institutions could be misleading because it is based
    largely on industry averages.  As previously mentioned, standard
    industry loss percentages do not consider the particular
    characteristics of the institution's loan portfolio and, as
    demonstrated in the report, can result in overstated or understated
    reserves.

    OCC did not cite the interagency policy statement in its comments
    regarding this or any other recommendation.  OCC stated that it
    believes banks' analyses should have an internal focus on the unique
    composition and historical loss experience of their own portfolios
    rather than on external comparisons with average experience of the
    industry.  OCC also stated that because no single approach has been
    determined to be the best, it does not require banks to use a
    specific method or time period to determine their own historical loss
    experience.  In addition, it stated that the method used will depend
    to a large degree on the capabilities of the individual bank's
    information systems.  OCC indicated that its examiners have been
    instructed, given the individual bank's systems capabilities, to
    determine whether a bank's methodology for evaluating the allowance
    produces reasonable estimates of probable losses which are inherent
    in its portfolio.

    Similar to OCC, FASB interpreted this recommendation to be a request
    that it develop a specific method for using loss experience--for
    example, that the last 3 years of experience should be used to
    estimate current year losses.  It believes banks should have the
    flexibility to use the historical data that are judged to be most
    reflective of its current loan losses.  By developing a specific
    method for using historical experience, FASB believes that banks'
    ability to use the most relevant data would be eliminated.

    While we agree conceptually with FASB and OCC that banks should be
    given the latitude to use what they determine to be the most
    meaningful approach to establishing reserves based on historical
    losses, we believe that in practice such flexibility would likely
    result in significant under-reserving in times of economic decline
    and over-reserving in times of economic prosperity.  In addition, as
    demonstrated in the report, major inconsistencies and therefore
    incomparability can result when institutions use methods which
    produce significantly varying amounts of reserves for the same loss
    exposure.

    We believe such inconsistency and incomparability result, in part,
    from the lack of clarifying guidance by FASB related to the types of
    "existing conditions" referred to in SFAS No.  5 that are indicative
    of probable loan losses, as well as the lack of guidance on specific
    actions to be taken if "future events" confirming the losses fail to
    occur.  We believe it is incumbent on FASB to provide clarification
    on these and other issues relating to the use of historical analyses
    to estimate probable loan losses.

          COMMENTS ON REQUIRED
          ANALYSES AND SUPPLEMENTAL
          RESERVES
    -------------------------------------------------------- Chapter 2:9.3

    Regarding our recommendation that all portions of the reserve,
    including any supplemental amounts, should be directly linked to and
    justified by documented analyses, all regulators agreed that
    documentation was important, but there were significantly differing
    views on whether large supplemental reserves should be allowed.  FASB
    did not believe it was responsible for providing the type of guidance
    we recommended, but agreed that the type of justification we
    described should support an appropriate estimate of reserves.

    FDIC, FRB, and OTS all agreed that documentation of the reserve
    analyses was important, but they believed that the interagency policy
    statement provided sufficient guidance on the required level of
    documentation of reserves.

    The interagency policy statement does state that the board of
    directors and management are expected to adequately document the
    institution's process for determining adequate loan loss reserves.
    However, this language is not significantly different from that
    contained in prior regulatory guidance.  We believe this level of
    guidance is too general, as demonstrated by the significant amounts
    of unjustified reserves discussed in the report.

    With regard to our findings and conclusions on unjustified
    supplemental reserves, FDIC and FRB indicated that from a regulatory
    perspective, reserves should be more conservatively estimated in
    order to protect the deposit insurance funds.  Therefore, they stated
    they would hesitate to suggest that an institution reduce its
    reserves, even if a reduction was indicated by the institution's
    analyses of probable existing losses.  We find this position to be
    contrary to their comments regarding the need for documented analyses
    to support the level of reserves, but consistent with the findings in
    the report.

    As indicated in the report, over 30 percent of the total reserves of
    7 of the 12 institutions we reviewed were supplemental reserves which
    were generally not justified by supporting analyses.  As demonstrated
    in the report, unjustified supplemental reserves can not only mask
    the improvement of a loan portfolio in good times, but can also
    enable an institution to conceal increases in loss exposure during
    bad times.  In addition, we believe these large unjustified
    supplemental reserves reflect institutions' and regulators'
    uncertainty as to how to best identify and measure probable losses in
    the loan portfolio--such uncertainty is likely to result in misstated
    reserves, especially when institutions rely heavily on supplemental
    reserves as "cushions" rather than doing the specific, comprehensive
    analyses necessary to identify existing probable losses.  We do not
    believe that reserves should be used by regulators as cushions for
    future uncertainties or that such cushions should be commingled with
    reserves whose purpose is to reflect losses already existing in the
    portfolio.  Further, we believe that if regulators are concerned
    about future losses, then direct capital appropriations could be made
    rather than using the loan loss reserve to address this concern.

    In its comments on this recommendation, OCC stated it believes some
    margin for error is desirable, but that it shares GAO's concerns
    about large supplemental reserves.  It believes that reducing the
    relative size and importance of this unallocated component of the
    allowance will produce a more refined and reliable estimate of an
    appropriate reserve level in most banks.  OCC also stated that it
    revised Banking Circular 201 in February 1992 and expects the
    long-term effects of this revised guidance, as well as the
    implementation of SFAS No.  114, to result in a reduction in
    supplemental reserves.

    We analyzed the revised Banking Circular 201 in connection with our
    1993 report on OCC bank examinations\12 and also in connection with
    our work for this report.  While the revised banking circular does
    provide sound general guidance, it does not provide for a methodology
    to quantify the various risk factors that are to be considered by
    banks and examiners in assessing the reserve.  Therefore, we believe
    Banking Circular 201 still provides too much latitude in banks'
    reserving practices.

    As discussed in the report, SFAS No.  114 only addresses reserving
    for individual loans identified by the institution for evaluation of
    collectibility.  It does not address overall reserving practices
    which encompass estimates of inherent, as well as specific, losses.
    Therefore, as stated in the report, we do not believe the application
    of SFAS No.  114 will resolve the problems we identified in the
    report with regard to supplemental reserves.

    FASB's comments on this recommendation indicated that while the type
    of analysis and documentation advocated by GAO should support an
    appropriate financial statement estimate, the form and detail is
    generally left to the institution and its auditor.  It stated that
    FASB does not prescribe how an entity should demonstrate its
    compliance with GAAP.

    While we agree that FASB should not be required to prescribe
    demonstration of GAAP compliance, we do believe it should develop or
    clarify GAAP standards when it becomes clear that existing guidance
    does not provide the desired result of consistent and reliable
    financial information.  We believe the report clearly demonstrates
    that the desired result is not being achieved with regard to
    supplemental reserves and therefore that FASB needs to take action.

    (See figure in printed edition.)Appendix I

    --------------------
    \12 Bank Examination Quality:  OCC Examinations Do Not Fully Assess
    Bank Safety and Soundness (GAO/AFMD-93-14, February 16, 1993).

    COMMENTS FROM THE FINANCIAL
    ACCOUNTING STANDARDS BOARD
    ============================================================ Chapter 2

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    The following are GAO's comments on the Financial Accounting
    Standards Board's letter dated July 27, 1994.

       GAO COMMENTS
    --------------------------------------------------------- Chapter 2:10

    1.  We do not believe the issues we identified in the report resulted
    from creditors ignoring the objectives of SFAS No.  5, but rather
    from the need for those objectives to be more definitively stated in
    terms of loan loss reserving practices.  For example, SFAS No.  5
    does not include specific parameters for determining what types of
    "existing conditions" are indicative of probable loan losses, nor
    what types of "future events" would confirm the existence and extent
    of the loss.  In addition, there is no specific guidance on what
    should be done if the future event does not occur.  FASB's belief
    that SFAS No.  5 provides sufficient guidance for establishment of
    loan loss reserves is contrary to the findings in our report.

    2.  We agree that recognizing future losses is a departure from GAAP.
    However, as indicated above, we do not believe the concept of what
    constitutes "future losses" versus "existing conditions that will
    ultimately be resolved when one or more future events occur or fail
    to occur" is at all clear with regard to estimation of loan loss
    reserves.  This lack of clarity was manifested in the inconsistent
    and, in some cases, potentially misleading reserving practices of the
    institutions in our sample.

    While we agree that loan loss accounting will always involve
    estimates and judgments, we believe that the current level of
    subjectivity in making these estimates and judgments is too high.  At
    a minimum, the basic concepts discussed above must be addressed by
    FASB in order to avoid the potential for "misrepresentation" in
    financial statements that currently exists in accounting for loan
    loss reserves.

    3.  See the "Comments and Our Evaluation" section in chapter 2.

    4.  We believe fair value is the most objective and accurate measure
    to determine the loss exposure on collateral dependent loans
    precisely because it is reflective of current economic events such as
    changes in interest rates and real estate values.  Once a loan has
    been identified as impaired, the current value of the collateral is
    the recoverable amount in the event of default and therefore should
    be the basis for the loss estimate.  While techniques for estimating
    fair value involve judgments, we believe such judgments are likely to
    be better estimates of loss exposure than the alternative approaches
    described in SFAS No.  114, because the basic premise behind the
    judgments is more sound.

    (See figure in printed edition.)Appendix II
    COMMENTS FROM THE FEDERAL DEPOSIT
    INSURANCE CORPORATION
    ============================================================ Chapter 2

    (See figure in printed edition.)

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    The following are GAO's comments on the Federal Deposit Insurance
    Corporation's letter dated July 14, 1994.

       GAO COMMENTS
    --------------------------------------------------------- Chapter 2:11

    1.  As stated in the report, we conducted case studies of 12
    depository institutions, each with total assets over $1 billion,
    which we judgmentally selected.  To include a cross section of
    depository institutions we selected institutions supervised by OCC,
    FRB, FDIC, and OTS.  Further, for geographic diversity, we selected
    institutions located in California, Maryland, New York, North
    Carolina, Texas, and Virginia.  It was not our objective to evaluate
    loan loss reserve methodologies of banks regulated specifically by
    FDIC or any other agency, but rather to evaluate this cross section
    of institutions to assess the overall reliability and comparability
    of their reserving practices.

    We interviewed examiners for two of the three FDIC-supervised
    institutions in our sample, and reviewed examination working papers
    for all three institutions.  We were not able to interview the
    examiner for the third institution, despite several efforts to do so.
    However, we were able to meet with officials of the institution to
    obtain the remaining information necessary to complete our work.

    As our work did not center on the quality of examinations or the
    adequacy of specific conclusions made by examiners, we did not find
    it practicable or necessary to inform FDIC examiners of the status of
    our work as it progressed.  Our findings were brought to the
    attention of FDIC headquarters officials in a draft of this report.

    2.  See the "Comments and Our Evaluation" section in chapter 2.

    3.  We recognize that the reserve is an estimate of probable losses
    inherent in the loan portfolio.  We also recognize that management's
    analyses of the reserve adequacy may include consideration of several
    scenarios.  However, the reserve recorded on the financial statements
    and call reports and used in determining capital adequacy is a single
    amount.  This amount, regardless of whether it is the best estimate
    within a range or the final result of a complex reserving model, must
    justifiably reflect existing losses in the loan portfolio which are
    probable and estimable.

    4.  While we agree that examiners have the ability to evaluate loan
    quality based on other factors, many other financial statement users
    do not.  The provision for loan losses is a key component in
    quarterly earnings calculations and is looked to by many financial
    statement users as the primary gauge of changes in loan quality.  The
    provision for loan losses and the related reserve are the only direct
    indicators of loan quality reported in the income statement and the
    balance sheet, respectively, of an institution.  These two financial
    statements are the primary vehicles through which results of
    operations and financial condition are reported to the public.  In
    addition, the provision and reserve are reported on regulatory call
    reports and are factored into calculations of regulatory capital.

    As stated in the report, the primary purpose of financial reporting
    is to provide information to report users which they can rely on for
    making business and economic decisions.  Financial information is
    most useful in making these decisions if it can be compared with
    similar information about other enterprises and with similar
    information for different periods of time or points in time for the
    same enterprise.  We do not believe that existing authoritative
    accounting or regulatory guidance provides for reliable and
    consistent reporting of loan loss provisions and related reserves,
    thus undermining the usefulness of financial reports of banks and
    thrifts.

    5.  The purpose of the reserve for loan losses is to reflect
    management's best estimate of probable losses currently existing in
    the loan portfolio.  We do not believe that reserves meeting this
    purpose should differ based on whether they are determined for
    creditor, investor, or regulator needs.  As stated in the report, we
    believe that current authoritative accounting and regulatory guidance
    for establishment of loan loss reserves are not sufficient to
    consistently meet these needs.  Reserves that are excessive in times
    of economic prosperity are symptomatic of the inadequacies in
    guidance, as are reserves that are deficient in times of economic
    decline.  The basic problem is the lack of a comprehensive,
    consistent approach which produces reserves that track with changes
    in the quality of the loan portfolio.

    (See figure in printed edition.)Appendix III
    COMMENTS FROM THE FEDERAL RESERVE
    BOARD
    ============================================================ Chapter 2

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    The following are GAO's comments on the Federal Reserve Board's
    letter dated July 13, 1994.

       GAO COMMENTS
    --------------------------------------------------------- Chapter 2:12

    1.  See the "Comments and Our Evaluation" section in chapter 2.

    2.  While we agree that examiners have the ability to evaluate loan
    quality based on other factors, many other financial statement users
    do not.  The provision for loan losses is a key component in
    quarterly earnings calculations and is looked to by many financial
    statement users as the primary gauge of changes in loan quality.  The
    provision for loan losses and the related reserve are the only direct
    indicators of loan quality reported in the income statement and the
    balance sheet, respectively, of an institution.  These two financial
    statements are the primary vehicles through which results of
    operations and financial condition are reported to the public.  In
    addition, the provision and reserve are reported on regulatory call
    reports and are factored into calculations of regulatory capital.

    As stated in the report, the primary purpose of financial reporting
    is to provide information to report users which they can rely on for
    making business and economic decisions.  Financial information is the
    most useful in making these decisions if it can be compared with
    similar information about other enterprises and with similar
    information for different periods of time or points in time for the
    same enterprise.  We do not believe existing authoritative accounting
    or regulatory guidance provide for reliable and consistent reporting
    of loan loss provisions and related reserves, thus undermining the
    usefulness of financial reports of banks and thrifts.

    (See figure in printed edition.)Appendix IV
    COMMENTS FROM THE COMPTROLLER OF
    THE CURRENCY
    ============================================================ Chapter 2

    (See figure in printed edition.)

    (See figure in printed edition.)

    The following are GAO's comments on the Comptroller of the Currency's
    letter dated August 2, 1994.

       GAO COMMENTS
    --------------------------------------------------------- Chapter 2:13

    1.  See the "Comments and Our Evaluation" section in chapter 2.

    (See figure in printed edition.)Appendix V
    COMMENTS FROM THE OFFICE OF THRIFT
    SUPERVISION
    ============================================================ Chapter 2

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    (See figure in printed edition.)

    The following are GAO's comments on the Office of Thrift
    Supervision's letter dated July 13, 1994.

       GAO COMMENTS
    --------------------------------------------------------- Chapter 2:14

    1.  See the "Comments and Our Evaluation" section in chapter 2.

    2.  The interagency policy statement does state that reserves should
    reflect losses expected over the remaining effective lives of
    classified loans, but does not provide specific guidance or minimum
    requirements for the use of migration analysis or other techniques to
    estimate losses in this manner.  The policy statement also states
    that reserves should reflect all estimated credit losses over the
    upcoming 12 months for loans that are not classified.  No rationale
    for the use of a 12-month time frame for these loans is provided in
    the policy statement.

    We believe that parameters are needed to ensure that all loss
    estimates represent existing conditions that are likely to result in
    losses during the period of time the institution holds the loans.
    These same criteria exist for all loans--classified or unclassified.
    Therefore, we do not believe the use of different loss time frames
    based on loan classifications is appropriate.  We believe the focus
    of authoritative accounting and regulatory guidance should be on
    identification of the types of existing conditions that are
    indicative of probable loan losses.  Once such a condition has been
    identified, then the estimated probable loss should be reserved for,
    regardless of whether the event which confirms that loss is expected
    to occur over the next 12 months or at some later point in the life
    of the loan.

    3.  We agree with OTS's comment and have changed the report
    accordingly.

    4.  The discussion in the report OTS refers to is an explanation of
    the objectives of using longer versus shorter time periods to
    determine historical loss rates.  The purpose of this discussion was
    to compare and contrast the different approaches--we did not express
    our view on the appropriateness of either approach.

    5.  As stated in the report, we reviewed AICPA audit and accounting
    guides for banks and savings institutions.  These guides present
    broad discussions relative to accounting for loan loss reserves, but
    they do not provide specific guidance that management can use to
    effectively address the concerns that we identified in the report.

    The AICPA auditing procedure study was designed to assist auditors of
    bank financial statements in developing an effective audit approach,
    rather than to provide detailed guidance on how management should
    establish loan loss reserves.  Further, neither FASB nor the AICPA
    considers such procedure studies to be authoritative accounting
    standards.

    6.  As stated in the report, we believe the interagency statement
    will encourage institutions to continue to use large unjustified
    supplemental reserves because it does not emphasize that inherent
    imprecision in loss estimates can result in overstatements as well as
    understatements of actual losses.  As a result, institutions may
    continue to add to their estimates to cover potential error even if
    the estimates are too high.  OTS's handbook, section 261, includes
    language similar to the interagency policy statement and states its
    position that if an association's reserve historically has been
    sufficient then the "margin for imprecision can be minimal." However,
    it does not define how institutions should calculate the margin for
    imprecision or what OTS means by minimal.

    MAJOR CONTRIBUTORS TO THIS REPORT
    ========================================================== Appendix VI

       ACCOUNTING AND INFORMATION
       MANAGEMENT DIVISION,
       WASHINGTON, D.C.
    -------------------------------------------------------- Appendix VI:1

    Linda M.  Calbom, Senior Assistant Director
    Daniel R.  Blair, Auditor-in-Charge

       DALLAS REGIONAL OFFICE
    -------------------------------------------------------- Appendix VI:2

    Kenneth R.  Rupar, Project Manager
    Amy E.  Lyon, Site Senior
    Matthew F.  Valenta, Evaluator

       NEW YORK REGIONAL OFFICE
    -------------------------------------------------------- Appendix VI:3

    David J.  Deivert, Site Senior

       SAN FRANCISCO REGIONAL OFFICE
    -------------------------------------------------------- Appendix VI:4

    John M.  Lord, Site Senior
    Yola Lewis, Evaluator