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Is making U.S. banks foresee trouble more trouble than it's worth?

Four thousand U.S. dollars are counted out by a banker counting currency at a bank in Westminster, Colorado November 3, 2009. REUTERS/Rick W
Four thousand U.S. dollars are counted out by a banker counting currency at a bank in Westminster, Colorado November 3, 2009. REUTERS/Rick W

By Dena Aubin

NEW YORK (Reuters) - Forcing banks to anticipate trouble in their loan portfolios by reserving more money on their balance sheets for potential loan losses seems like a no-brainer, especially after the 2007-2008 credit crisis that shook world economies.

So why is the U.S. Financial Accounting Standards Board (FASB) meeting criticism over a proposal to do just that?

One reason is a fear that banks could abuse a new standard, proposed in December by FASB, by using increased loan loss reserves to smooth out the profits they report to Wall Street.

"If I had to dream up a way to manage earnings, I think this is probably as good as it gets," said Edward Trott, a former member of FASB, which writes the standards for the United States' Generally Accepted Accounting Principles (GAAP).

FASB is seeking comments on the proposal through May 31. Its details may change. FASB has not set an implementation date. Analysts said it would likely not be effective before 2015.

The FASB proposal would allow banks to use their own forecasts of future loan losses, injecting more judgment and bias into the process, said Jack Ciesielski, publisher of the Analyst's Accounting Observer.

Banks in essence could stuff their balance sheets with extra reserves and use them later to smooth earnings, he said.

"The question isn't so much will somebody do bad accounting with this; somebody will," Ciesielski said.

"The question is, will it become widespread, accepted practice to do the accounting badly?"

RESERVES CITED IN CREDIT CRISIS

FASB spokeswoman Christine Klimek said in a statement that estimating credit losses involves judgment under any accounting approach. The proposal is meant to fix delayed recognition of credit losses, a problem during the crisis, she said.

Under current rules, banks set aside reserves when there are already signs of a loss, a so-called "incurred-loss" approach.

The new "expected-loss" standard would require banks to look ahead and reserve for expected losses when a loan is originated.

Defaults on loans and other debt battered banks worldwide during the global financial crisis, and many institutions had to be bailed out with government funds because they had not set aside enough for the massive losses.

Since then banking regulators have proposed a host of reforms to help banks better withstand financial shocks.

Several regulators, including officials at the Treasury Department and the Comptroller of the Currency, have urged timelier reserves as one needed reform.

A better tactic would have been to require loans to be marked at fair value, which already includes forward-looking information, Trott said. Fair value, or "mark-to-market," is based on prices in the capital markets, a more neutral number than figures companies themselves come up with, he said.

Reserve calculations also will be difficult to audit because they will include subjective future forecasts, Trott said.

FASB proposed fair value for loans in 2010 but backed away after opposition from the banking industry. Under a new proposal in February, most simple loans would still be marked at historical cost.

RESERVES ATTRACT SEC SCRUTINY

The U.S. Securities and Exchange Commission has long scrutinized companies that use excess reserves to massage earnings. In addition to banks, many companies use reserves to cover such losses as litigation and environmental costs.

The SEC declined comment on FASB's proposal.

Past efforts of regulators to curb earnings management has led some banks to keep their reserves to a minimum, the American Bankers Association, a banking industry lobbying group, said in a January report on the FASB proposal.

The ABA said it supports a change from the strict incurred loss standard for loans, though requiring forecasts too far into the future would not be reliable.

A spokesman for the ABA could not be reached for comment.

FASB Chairman Leslie Seidman has estimated that the new standard might force some banks to boost loan loss reserves by as much as 50 percent.

Earnings also might be more volatile as banks adjust their expenses each quarter for expected credit losses, Fitch analysts said in a report last month.

(Editing by Kevin Drawbaugh and Kenneth Barry)

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