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

What's new on AEI

Making Ryan's tax plan smarter
image The teacher evaluation confronts the future
image How to reform the US immigration system
image Inversion hysteria
AEI on Facebook
Events Calendar
  • 01
    MON
  • 02
    TUE
  • 03
    WED
  • 04
    THU
  • 05
    FRI
Wednesday, September 03, 2014 | 9:00 a.m. – 10:30 a.m.
From anarchy to Augustus: Lessons on dealing with disorder, from Rome’s first emperor

We invite you to join us for two panel discussions on how Augustus created order from chaos 2,000 years ago, and what makes for durable domestic and international political systems in the 21st century.

Wednesday, September 03, 2014 | 12:00 p.m. – 1:30 p.m.
Multiple choice: Expanding opportunity through innovation in K–12 education

Please join us for a book launch event and panel discussion about how a marketplace of education options can help today's students succeed in tomorrow's economy. Attendees will receive a complimentary copy of the featured book.

Thursday, September 04, 2014 | 12:00 p.m. – 1:30 p.m.
How conservatives can save the safety net

Please join us for a luncheon event in which our panel will discuss what conservatives can learn from how liberals talk and think about the safety net and where free-market economics, federalism, and social responsibility intersect to lift people out of poverty.

No events scheduled this day.
No events scheduled this day.
No events scheduled today.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.