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



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)


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



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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



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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
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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

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