An Old Lesson on Bank Reserves
Letter to the Editor

Comptroller of the Currency John Dugan forcefully proposes that we need "stronger reserves during the boom years" ["Dugan: Turmoil Shows Need for Reserve Leeway," March 3, page 3]. Former Comptroller Gene Ludwig points out that "accounting rules caused many banks to enter this down cycle with inadequate reserves" ["Viewpoint: Crisis Demands Flexibility on Accounting," Feb. 25, page 9].

Thus they both enter the jousting with the SEC and the FASB over whether during credit expansions, when current delinquencies and losses are low and everybody is feeling happy, that indeed precisely because of this happiness, greater loss reserves are necessary. In the wake of the global bust, this has become a global debate.

To put the whole issue in perspective, just imagine the crusty old chief credit officer pronouncing to the aspiring young banker (me): "Bad loans are made in good times."

This eternal financial truth is all you need to know in order to understand why Messrs. Dugan and Ludwig are right and the accounting theoreticians of the SEC and the FASB are wrong yet again. When the latter oppose building reserves in the aforementioned good times, they claim this would mean "cookie jar accounting" during periods of bumper profits. But the essential point is that the "bumper profits" of the credit expansion are not real--they are an illusion of the good times.

"Bad loans are made in good times."

This illusion then turns into real cash outflows: big bonuses, dividends and outsized stock repurchases, thus higher leverage. It reflects the human tendency noted by Henry Thornton in his 1802 classic on the "Paper Credit of Great Britain": "A high state of confidence contributes to make men provide less amply against contingencies." Nothing has changed in the intervening 200 years, including the fact that banking always faces plenty of contingencies to be provided against.

The real profit is much less than the illusion, because of the inevitable losses the good-time loans will create, even though you can't see them yet in particular. Not to reserve against them is as foolish as not reserving against a life insurance policy because the insured didn't die this year.

George Champion, the chairman of Chase Manhattan Bank in the 1960s, recommended in 1978 that banks "increase the reserve for bad debts to a point of having at least 5% of total loans.

This would not be out of line with the enormous losses that had to be written off in the last few years," he observed three decades ago. "Don't apply for privileges in Washington. You lose your strength. You lose your independence. Don't get in a position where you are going to have to rely on the government to bail you out."

Well, with more old-fashioned reserves, we can do better in the next cycle.

Alex J. Pollock is a resident fellow at AEI.

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Alex J.
Pollock
  • Alex J. Pollock is a resident fellow at the American Enterprise Institute (AEI), where he studies and writes about housing finance; government-sponsored enterprises, including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks; retirement finance; and banking and central banks. He also works on corporate governance and accounting standards issues.


    Pollock has had a 35-year career in banking and was president and CEO of the Federal Home Loan Bank of Chicago for more than 12 years immediately before joining AEI. A prolific writer, he has written numerous articles on financial systems and is the author of the book “Boom and Bust: Financial Cycles and Human Prosperity” (AEI Press, 2011). He has also created a one-page mortgage form to help borrowers understand their mortgage obligations.


    The lead director of CME Group, Pollock is also a director of the Great Lakes Higher Education Corporation and the chairman of the board of the Great Books Foundation. He is a past president of the International Union for Housing Finance.


    He has an M.P.A. in international relations from Princeton University, an M.A. in philosophy from the University of Chicago, and a B.A. from Williams College.


  • Phone: 202.862.7190
    Email: apollock@aei.org
  • Assistant Info

    Name: Emily Rapp
    Phone: (202) 419-5212
    Email: emily.rapp@aei.org

What's new on AEI

image Getting it right: US national security policy and al Qaeda since 2011
image Net neutrality rundown: What the NPRM means for you
image The Schuette decision
image Snatching failure from victory in Afghanistan
AEI on Facebook
Events Calendar
  • 21
    MON
  • 22
    TUE
  • 23
    WED
  • 24
    THU
  • 25
    FRI
Wednesday, April 23, 2014 | 12:00 p.m. – 1:30 p.m.
Graduation day: How dads’ involvement impacts higher education success

Join a diverse group of panelists — including sociologists, education experts, and students — for a discussion of how public policy and culture can help families lay a firmer foundation for their children’s educational success, and of how the effects of paternal involvement vary by socioeconomic background.

Thursday, April 24, 2014 | 12:00 p.m. – 1:30 p.m.
Getting it right: A better strategy to defeat al Qaeda

This event will coincide with the release of a new report by AEI’s Mary Habeck, which analyzes why current national security policy is failing to stop the advancement of al Qaeda and its affiliates and what the US can do to develop a successful strategy to defeat this enemy.

Event Registration is Closed
Friday, April 25, 2014 | 9:15 a.m. – 1:15 p.m.
Obamacare’s rocky start and uncertain future

During this event, experts with many different views on the ACA will offer their predictions for the future.   

Event Registration is Closed
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.