Bank reports must show 'fair value' of loans

January 05, 1993|By New York Times News Service

Banks will be required in annual reports issued early in 1993 to divulge for the first time their estimates for the "fair value" of their loans -- a change long sought by critics who have contended that overly generous accounting rules allowed banks hide losses on bad loans.

Banks now carry loans on their books at their original value if the bank expects to be repaid in full, even if a borrower gets in trouble and the bank would suffer a loss from selling the loan.

The new disclosure will be required only as a footnote and will not affect banks' profits or the capital they have accumulated to absorb future losses. But it could be a harbinger of more far-reaching changes in the accounting rules, which are crucial to customers, investors and regulators trying to measure a bank's strength.

Early indications by accountants and bankers are that the disclosure will not portray banks in a weaker light, contrary to the expectation of some of its proponents.

William P. Hannon, a partner at KPMG Peat Marwick, a leading accounting firm for banks, said the new rule "is not going to show the banking industry facing new problems."

Properly run banks have already acknowledged bad loans by subtracting from their profits an adequate provision for loan losses, he said. And the rule adopted by the Securities and Exchange Commission gives banks enough flexibility to estimate fair value" for loans on historical experience, not just the fire sale price that might be required for quick sale.

That conclusion is much different from the expectation of Rep. Henry B. Gonzalez, D-Texas, chairman of the House Banking Committee, who said in a letter in November to Federal Reserve Chairman Alan Greenspan that the fair value accounting would pierce "accounting camouflage" and "prove numerous banks to be insolvent."

But even if the first application of the rule is not as painful as Mr. Gonzalez expects, bankers and other analysts worry that future versions of fair value accounting rules might be less flexible and require lower estimated values for loans even when a bank has no intention of selling a loan.

Federal bank regulators are expected to announce this month their own proposals for disclosing "fair values" and the Financial Accounting Standards Board, which makes rules for the accounting industry, is working on proposals to make "fair value" the core of bank accounting and not just a footnote.

Such a policy could discourage banks from issuing any but the safest loans, thereby hurting the economy and making it harder for small- and medium-sized businesses to grow.

Those warnings and objections that estimates of loans' fair value may be fraught with error have not stopped the SEC, some members of Congress and academic experts from espousing 'fair value," also called fair market value or mark-to-market value, accounting.

"Right now we have a bank accounting system that is backward looking, based on costs rather than today's prices," said Lawrence J. White, an economics professor at the New York University Stern School of Business.

"It's a system that presents too many opportunities to understate losses from bad loans and to understate the severity of the problems at a troubled bank," he said, adding that estimates of fair market values might be wrong, but would be a step in the right direction.

In 1990 and 1991 the U.S. General Accounting Office, responding to congressional requests for studies about the causes of the savings and loan debacle and rise in bank failures, issued reports concluding that bank accounting rules made it too easy for bankers and regulators to overlook or ignore losses on bad loans.

Bankers and regulators concede there are abuses of the historical cost accounting, but paraphrasing Winston Churchill, they say it is the worst system except for all the others.

Mr. Greenspan said in a speech in November that the issuing of loans to a bank's local customers that can not be readily sold (and for that very reason would probably be worth less than their face amount) "is the competitive reason for banks' existence."

To measure such a loan by its market value, the price it might fetch in a quick sale "is a misapplication of accounting principles" that does not accurately measure a bank's success in avoiding bad loans, he said.

The system now used says loans should be carried at the bank's best estimate of the payments it will receive from the borrower.

When a loan becomes troubled, banks subtract from their profits an amount, called a loan loss provision, based on the shortfall in ++ repayment they expect, plus some additional amount to cover problems not foreseen. When a loan gets too dicey, it is written off as a loss in whole or in part, and the writeoff is subtracted from reserves.

In 1990 and 1991 banks got a hint of fair value accounting when federal examiners prodded them to report their losses on commercial real estate loans more quickly than they wanted.

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