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Has Congress sparked a banking crunch?
Sarbanes-Oxley reforms make it nearly impossible for banks to prepare for the credit cycle's turn. Banks are forced to cut reserves for bad loans just when they need them.
By Jim Jubak
Remember Sarbanes-Oxley? The act Congress passed in 2002 was intended to prevent accounting fraud like that perpetrated by Enron and WorldCom. In the banking sector, though, the law designed to ensure that companies report numbers that accurately reflect their financial conditions is instead forcing banks to paper over problems they know are coming.
The unintended consequence of post-Enron accounting reform could be a meltdown in the U.S. banking sector.
How do I know? Bankers themselves (and several accountants doing work for banks) have told me so in e-mail responses to my Sept. 9 column, "Do-nothing Fed is dangerously disengaged."
In that column, I took the Federal Reserve to task for talking the talk when it came to blaming consumers for a potential housing bubble, but for failing to walk the walk when it came to banks and other lenders who were relaxing credit quality standards so they could make more and more loans to less- and less-qualified borrowers.
Many banks were making the problem worse, I wrote, by decreasing the money they set aside to pay for future loan defaults. The Fed's failure to put pressure on banks to toughen lending standards and to reserve more, I continued, meant that when the current easy-money credit cycle turns -- as credit cycles always do -- and the less-qualified borrowers default on their loans in higher numbers, the mess might be bad enough to endanger some banks.
In their e-mails, the bankers took me to task. Not for criticizing the Federal Reserve, but for missing the bigger story: That's the way that the Sarbanes-Oxley accounting reforms have made it just about impossible for banks to prepare for the credit cycle's turn. Accountants and the Securities and Exchange Commission (SEC) are applying Sarbanes-Oxley in a way that forces banks to cut reserves for delinquent and bad loans just when they need to put money aside for the rainy days that will come, these bankers say.
Related news and commentary on MSN Money
A rough ride on the credit cycle
The problem begins with the credit cycle. At the top of a credit cycle, borrowers have plenty of cash, make their payments on time and pay back their loans without difficulty. It helps that at the top of a credit cycle, money is plentiful and cheap -- thanks often to the Federal Reserve -- so that borrowers are getting their loans at very low interest rates and have relatively modest interest payments.
In this environment, banks and other lenders see the number of delinquent loans and the number of loans that actually go into default drop. Banks cut their reserves for bad loans and see their earnings rise as a result. Beguiled by this level of loan performance -- and often, at this point in the cycle, with lots of money to lend -- lenders stretch their credit standards and make loans to borrowers that they would have previously rejected as too risky.
But these sunny days don't last forever. Maybe the economy slows so that borrowers have less cash flow to use to meet their obligations. Maybe inflation rises, forcing borrowers to pay higher material prices (if the borrower is a business) or higher fuel and heating costs (if the borrower is a consumer) rather than paying back debt. Maybe interest rates go up, so that the monthly payments on floating rate and short-term debt start to rise. Or maybe all of these things happen at once.
Gradually, the number of delinquent borrowers begins to rise. Gradually, the number of loans in actual default begins to rise.
As that happens, banks increase their bad-loan reserves. They raise the rates they charge to borrowers to reflect the higher costs of doing business -- and the greater risk in a loan. They tighten up their lending standards, now denying loans to potential borrowers they would have gladly approved at the top of the cycle.
At some point, the credit cycle bottoms. Tighter credit quality standards reduce the number of loans outstanding and thus the number of bad loans. Banks, seeing fewer defaults, stop increasing their reserves for bad loans. And they gradually look for more lending opportunities, often first offering their best customers more capital at better terms.
Right now, a number of historical measures indicate that we're near the top of the credit cycle. At individual banks, charge-offs for bad loans have hit historic lows. At KeyCorp (KEY, news, msgs), for example, charge-offs for bad debt in the second quarter were the lowest in the bank's history. According to FIG Partners, the loan-loss reserves at the country's 50 largest banks are now lower as a percentage of loans than at any time since 1990.
So sometime soon, we're due to take a turn from the top of the cycle toward the bottom.
A ban on rainy-day funds
The distance from the top to the bottom of the cycle depends on many things. The general economy, for one. The growth in money supply controlled by the Fed. The number of loans made with lax standards that later go bad. The foresight of banks in putting away reserves while the sun shone at the cycle's top for the inevitable rainy days at the cycle's bottom.
If banks have put away too little at the top, they will have much less ability and desire to make loans at the bottom, when they have to rush to put extra cash into their underfunded reserve funds. If the underfunding was bad enough, a bank or two may even fail, sending a wave of gloom through the banking sector that can deepen the bottom of the cycle as fearful banks refuse to lend.
And that under-reserving at the top of the credit cycle is exactly what my banker correspondents worry is happening right now, thanks to the way accountants and the SEC are interpreting Sarbanes-Oxley.
"In past cycles, we have 'squirreled away' loan-loss reserves in the good times to absorb the impact of the inevitable deterioration in credit quality at the end of the cycle," wrote one e-mailer who has been a bank director for more than two decades. "This is exactly what a fiscally sound business would do. However, 'it's different this time,' for reasons that go right back to Sarbanes-Oxley."
Bank directors and officers want to increase the bank's loan-loss reserve, my correspondent wrote, to keep pace with the growth in the bank's portfolio of loans, but the bank's public accountants won't allow it. The accountants say that the bank can only put aside reserves if it can identify specific loans that will go bad. Putting money aside as unallocated reserves -- reserves that aren't attached to a specific problem loan but are designed to head off a future turn in the credit cycle -- aren't allowed by Sarbanes-Oxley, the accountants have decided. Unallocated loan-loss reserves are an attempt to smooth earnings of exactly the kind that is prohibited by Sarbanes-Oxley.
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