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35 » VISIT US ONLINE @ DSNEWS.COM DO BANKS WAIT UNTIL ECONOMIC DOWNTURNS TO BUILD UP LOAN- LOSS RESERVES? One subject of much debate since the financial crisis has been what determines how much money banks keep in their reserve accounts to offset losses from loans that default, known as loan-loss provisions. A report from the Federal Reserve Bank of Cleveland written by Constantine Madias and Lakshmi Balasubramanyan discusses the issue of how banks determine their reserve levels for loan-loss provisions. e authors found in the data on U.S. banks covering the last several decades, banks tend to undercontribute to the reserves during periods of prosperity, which forces them to build up reserves during less- than-prosperous economic times. Rules are in place to prevent bank managers from manipulating the timing (level) of the bank's reported earnings by using the reserve accounts. e allowance for loan and lease losses (ALLL), which is the balance of the reserve account, does not impact the bank's earnings; however, reported earnings are reduced when banks engage in a practice known as loan-loss provisioning, which is adding to the reserve account. As a result of the earnings being reduced, the shareholders' equity is also reduced. "e accounting profession prefers this approach because it produces financial statements that reflect companies' current situations more accurately," the authors stated. "But financial regulators, who are more focused on the safety and soundness of banks, prefer an approach that helps banks accumulate an adequate supply of reserves before they are needed." e authors noted that the typical scenario for economic downturns is for the number of problem loans to rise, along with loan-loss provisions. During the financial crisis of 2008 and 2009, commonly known as the Great Recession, net charge-offs totaled more than $50 billion, a historically high level. Meanwhile, the provisions for loan and lease losses more than tripled from 2007 to 2008 at the onset of the recession—from less than $20 billion to more than $70 billion in just a year. "In all likelihood, banks were increasing their loan-loss provisions at a time when it was more difficult and costly for them to do so," the authors said. e authors compared the numbers on loan- loss provisions, which are a bank's expectations of future loan losses, with net charge-offs, which are actual losses, from three different periods and found that the elevated level of loan-loss provisions as a percentage of net charge-offs during the 2008 crisis (187 percent) was still well below the ratio during the savings and loan crisis from the mid-1980s until the mid-1990s. e ratio of loan-loss provisions as a percentage of net charge-offs in 1987 during the middle of that crisis was well above 500 percent, according to the authors. By comparison, in the 10 years prior to the 2008 crisis, the ratio averaged 110 percent. e authors announced that new rules for loan-loss provisioning by the Financial Standards Accounting Board (FASB) are currently in the works. "e old approach (incurred loss), which does not allow banks to recognize loan losses until the actual default has occurred, will be replaced with a forward-looking, expected loss approach," the authors wrote. "While the size of the losses will not likely change, the timing of their appearance on the balance sheet will. e new expected loss approach will entail more discretion on the part of bank managers." CHASE CEO: 'BIG, DUMB BANKS' SHOULD BE ALLOWED TO FAIL Should banks actually be allowed to fail? Well, the "big, dumb" ones should, according to JPMorgan Chase chairman and CEO Jamie Dimon, who blasted the institutionalized belief that mega-dollar bailouts for badly run banks is good for the economy. Dimon's comments that banks should be allowed to fail is the latest in a growing movement among top-tier banking execs who believe that financial institutions earn their own success or failure. In June, Wells Fargo's former CEO, Dick Kovacevich, called the Troubled Asset Relief Program, or TARP, "an unmitigated disaster" for several reasons, including institutionalizing the concept that there are some banks that can't be allowed to go under. For Dimon, if a bank can't keep its house in order, it does not deserve help getting out of the trouble it caused itself. e call to end bailouts has even become a political campaign issue. In October, Hillary Clinton stressed to TV host Stephen Colbert the importance of investors knowing that their banks could fail, and that the price of mismanagement should be suitably harsh. Dimon's comments also coincide with a series of bills passed by the House Financial Services Committee that aim to boost economic growth by increasing the accountability of financial regulators. At the sessions, Committee Chairman Jeb Hensarling (R-Texas) said that the Dodd-Frank Act of 2010, rather than eliminating the "too big to fail" concept, has simply made more bureaucrats more untouchable and left more taxpayers to pick up an increasingly hefty bill for the economy in the wake of TARP assistance. "Banks should be allowed to fail," said Dimon, speaking to 300 CEOs and senior executives at the Fortune Global Forum in San Francisco. "For the American public, [bailouts] should be called 'bankruptcy for big, dumb banks.'" Noteworthy is that JPMorgan Chase accepted $25 billion in TARP assistance in 2008, which Dimon at the time said the bank accepted "because we were asked to." e bank has since paid the money back, plus more than $1 billion in fines related to the company's acquisitions of Bear Stearns and Washington Mutual. 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