TESTIMONY OF HARVEY J. GOLDSCHMID, GENERAL COUNSEL U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING LOAN LOSS ALLOWANCES BEFORE THE SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND CONSUMER CREDIT COMMITTEE ON BANKING AND FINANCIAL SERVICES U.S. HOUSE OF REPRESENTATIVES JUNE 16, 1999 Chairwoman Roukema, Congressman Vento, and Members of the Subcommittee: I am pleased to appear today to testify on behalf of the Securities and Exchange Commission (“Commission„ or “SEC„) regarding loan loss allowances. I appreciate the opportunity to discuss the importance of transparent financial reporting to investors and the marketplace and the SEC’s position on disclosure, documentation, and accounting for loan loss allowances. We believe significant progress is being made by the SEC and the banking agencies in addressing areas of mutual concern. I want to assure you that the SEC remains committed to working cooperatively and constructively with the banking agencies, financial institutions,[1] and users of financial information on these important issues.[2] As a preliminary matter, I want to state, as clearly as I possibly can, that the SEC does not want, nor has it ever wanted, financial institutions to artificially lower loan allowances or ever have inadequate allowances. As Chairman Levitt stated on May 19th: Some . . . have interpreted our efforts on bank reserves to suggest that the SEC thinks reserves are too high and should be lowered. That couldn’t be further from the truth . . . . [T]he SEC and the federal banking agencies recently recognized that because instability in certain global markets is likely to adversely impact affected institutions’ portfolios, higher allowances for credit losses may be required than were appropriate in more stable times. I want to emphasize -- it is not our policy that institutions artificially lower reserves or ever have inadequate reserves. But we do care about banks following GAAP.[3] The SEC’s mandate is to protect investors and the public interest; the Commission carries out this mandate, in part, by requiring public companies to make full and complete disclosure in accordance with generally accepted accounting principles (“GAAP„). The SEC cares a great deal about transparency of financial reporting by public companies, whether they are banks, manufacturers, or high-tech Internet firms. One of the lessons taught by the savings and loan (“S&L„) crisis of the 1980s, and the recent experience in Asia, was the critical importance of reliable, consistent, comparable, and transparent financial reporting. GAAP provides the framework to achieve those objectives. As discussed below, the Financial Accounting Standards Board (“FASB„) recently provided additional guidance to assist banks in accounting for loan loss allowances in accordance with GAAP. We strongly support the provision of that guidance and the private sector standards-setting process through which GAAP is established with input from constituent groups, agencies including the SEC, and other interested parties. As FRB Chairman Greenspan, recently put it: Transparent accounting plays an important role in maintaining the vibrancy of our financial markets. The success of the U.S. accounting model has been due, in no small part, to the private sector’s significant involvement in the process. An integral part of this process involves the Financial Accounting Standards Board (FASB) working directly with its constituents to develop appropriate accounting standards that reflect the needs of the marketplace. . . . [T]he process by which we set accounting standards dictates the quality of the end result. It is important that our institutions and markets continue to benefit from credible, impartial, and useful financial information provided in accordance with sound accounting and disclosure standards. For its part, the Federal Reserve has long supported the development and promulgation of strong accounting and disclosure standards, both domestically and abroad.[4] In a joint interagency letter, dated March 10, 1999, the banking agencies and the SEC reaffirmed the policy set by Congress that financial institutions should follow GAAP.[5] Financial institutions’ adherence to GAAP is one of the best protections against the risk that concealed financial problems will escalate into another disaster like the S&L crisis. GAAP provides the needed transparency in financial statements for investors to evaluate their investments. GAAP also allows bank boards of directors to properly evaluate bank managers. Additionally, GAAP enables bank boards of directors and bank agencies to assess the safety and soundness of banks. My testimony will address: (i) the need for transparency to prevent surprises about the financial condition of financial institutions; (ii) possible misconceptions about the SEC’s review of financial statements of financial institutions; (iii) the SEC’s requirement of transparent financial reporting; (iv) significant joint efforts of the SEC and banking agencies to ensure that financial reporting policies provide the transparency needed by investors, consistent with safety and soundness objectives; and (v) ongoing efforts to address the concerns of the SEC and banking agencies and their respective constituencies. THE NEED FOR TRANSPARENT FINANCIAL REPORTING Transparent Financial Reporting Protects the Financial Markets. The goal of the SEC’s disclosure system is to promote honest and efficient markets and informed investment decisions through full and fair disclosure. Investors are more confident when they can be sure that disclosures are reliable and complete. Transparency in financial reporting -- that is, the extent to which financial information about a company or bank is visible and understandable to investors, other market participants, and regulators -- plays a fundamental role in making our markets the most efficient, liquid, and resilient in the world. Transparency enables bank regulators, creditors, investors, and the market to evaluate the safety and soundness of a financial institution. Moreover, in addition to helping investors make better decisions, transparency increases confidence in the fairness of the markets. Further, transparency is important to corporate governance because it enables the board of directors to evaluate how effective management has been in managing the business, and for example, to take early corrective actions to address deterioration in the financial condition of the company or bank. Therefore, it is critical that all public companies, including publicly held financial institutions, provide a comprehensive and reliable portrayal of their financial condition and performance. With transparency in financial reports, there are no surprises. Recent events in the world’s markets have been painful reminders of what can happen when investors and regulators do not have a comprehensive and reliable picture of businesses. The turbulence in the Asian financial markets[6] and the nation’s past experience with the crisis in the savings and loan industry and bank failures are stark examples of the dangers of not knowing the true financial condition and performance of an institution until it is too late. In these situations, obfuscation hindered the markets’ ability to apply the necessary discipline to cause financial institutions to act prudently. “Market discipline can only work if market participants have access to timely and reliable information that enables them to assess a bank’s activities and the risks inherent in those activities.„[7] As we have seen in the Asian markets, serious consequences can result from the obstruction of market discipline and the resulting skepticism. In Asia, these consequences included flight of capital and greater cost of capital.[8] At its worst, lack of transparency in financial reporting can produce market panic, market disruptions, and threatens the safety of the banking system. GAAP Provides Transparency, Consistency, and Comparability. Investors, regulators, and creditors expect clear, consistent, comparable, and reliable reporting of events as they occur. Accounting standards assure that financial information is presented in a way that facilitates informed judgments. For financial statements to provide the information that investors and other decision makers require, meaningful and consistent accounting practices are necessary. Such practices must be applied in a like manner by companies in like circumstances. GAAP is the backbone of transparent financial reporting. GAAP is the framework for the accounting -- that is, the recognition, measurement, and disclosure -- required for the sale of securities and financial reporting of all public companies, including financial institutions. As the SEC, FDIC, FRB, OCC, and OTS recently agreed, all depository institutions should record and report their allowances for loan losses in accordance with GAAP.[9] The S&L Crisis Taught the Importance of Adherence to GAAP. Some have suggested that the S&L crisis is a justification for excess loan loss allowances. To the Commission, however, the S&L crisis reveals the importance of compliance with GAAP. In the period leading up to the S&L crisis, banks and thrifts used regulatory accounting practices (“RAP„) to report financial information to their federal regulators. RAP was predicated on GAAP, but departed from GAAP in significant ways. In particular, RAP modified GAAP in a manner that allowed insolvent institutions to appear to have positive net worth.[10] RAP usually resulted in higher reported income and retained earnings than would have been reported under GAAP. These overly permissive accounting practices permitted thrifts that were having financial difficulties not only to avoid exposure of their insolvency but also, at the same time, enabled them to engage in rapid expansion. With the S&L crisis still fresh in their minds, Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991.[11] Few times in our nation’s history has the need for following GAAP been more obvious than during that crisis. From a safety and soundness standpoint, Congress wanted financial reports from the banks to their regulators that: (i) accurately reflect the banks’ capital; (ii) facilitate the effective supervision of banks; and (iii) when needed, facilitate prompt corrective action at the lowest cost to the bank insurance funds.[12] Standing at this crossroads, Congress chose to require banks to follow GAAP (or more stringent standards)[13] when preparing these reports. By choosing GAAP, Congress was not sacrificing adequate allowances. Congress chose GAAP because it provides a clear picture of the financial condition and performance of a bank, which gives regulators the information that they need to suggest changes to the bank’s capital levels. The thrift crisis confirmed that effective regulation of financial institutions requires a reliable portrayal of the institution’s financial position and results of operation. Adherence to sound accounting principles promotes that result. In the aftermath of that crisis, and as underscored by the recent turmoil in Asia, it is widely recognized that all public companies, including banks, should work within the parameters of GAAP. Transparency of Allowances for Loan Losses Is Critical. Loans are the largest component of most financial institution’s assets. Allowances[14] are an estimate of the probable amount of loans that will not be repaid based on current events. Accordingly, in both good economic times and bad, transparent and consistent reporting of allowances for loan losses is critical to the safety of our financial markets. Excessive or inadequate allowances not in accordance with GAAP can lead to significant problems for investors, regulators, creditors, or anyone who needs to know the true financial condition and performance of the entity. If allowances are stretched thin in bad times and padded in good times, then the financial statements of financial institutions would not disclose and reflect actual credit quality and amount of losses in the institutions’ loan portfolios on a timely basis. As a result, investors, regulators and others would not have a reliable gauge of the credit risks in that portfolio. Nor would investors have a true picture of the real capital or earnings of financial institutions. Further, the distortion of earnings may mislead a bank’s board of directors and regulators about the actual level of safety and soundness of the bank.[15] Unsafe conditions at the institution could be camouflaged. As a result, needed corrective measures or intervention may be postponed, resulting in harm to the particular financial institution and to the system as a whole. In 1994, the GAO expressed the concern that improper treatment of loan loss allowances (referred to as reserves by the GAO): . . . could allow bank management to avoid recording loss provisions or recoveries to reflect these changes in loss exposure. Such use of unjustified supplemental reserves can conceal critical changes in the quality of an institution’s loan portfolio and undermine the credibility of financial reports. Further, the use of reserve cushions which have been built up over time to absorb subsequent loan quality deterioration could impede regulators’ ability to identify, between examinations, a decline in the financial condition of an institution early enough to take timely corrective action.[16] Concerns about loan loss allowances are not new to any of us. These concerns, as they relate to proper use of GAAP, were expressed during the 1980s in response to the S&L crisis. Nearly five years ago, in 1994, the GAO warned us about the continuing problem of inappropriate accounting for allowances and the resulting harm. The recent problems in Asia amplify these concerns. This history highlights the need to be mindful of the lessons to be learned from those experiences. DISPELLING POSSIBLE MISCONCEPTIONS ABOUT THE SEC’S INTERACTION WITH FINANCIAL INSTITUTIONS The SEC’s relationship with financial institutions stems from its mandate to assure full and fair disclosure. To carry out its mandate, the Commission staff reviews registration statements, proxy statements, and other documents filed with the Commission by public companies, including financial institutions. It is during this review process that the SEC works most closely with individual financial institutions. We would like to clarify the SEC’s position on allowances for loan losses and how the SEC staff reviews the filings of financial institutions. The SEC Is Not Requiring Banks to Artificially Lower Allowances. Some have suggested that the SEC is requiring all banks to reduce their allowances. That is simply not true. The SEC does not want institutions to ever have allowances that are inadequate. The SEC acknowledges that the estimate of loan losses is inevitably imprecise and may fall within a range of estimated losses. In accordance with GAAP, an institution should record its best estimate within the range of credit losses, including when management’s best estimate is at the high end of the range. Further, we realize that a high degree of management judgment is required in the determination of an appropriate loan loss allowance.[17] In addition, we recognized, along with the banking agencies, that “today instability in certain global markets, for example, is likely to increase loss inherent in affected institutions’ portfolios and consequently require higher allowances for credit losses than were appropriate in more stable times.„[18] Moreover, for most banks selected for review by the SEC staff based on the process described below, the staff has requested only that the bank provide additional explanations of its disclosures in its financial statements or Management’s Discussion and Analysis (“MD&A„)[19] regarding the allowance and provision for loan losses. The staff questions allowances that appear too low as well as those that appear too high as compared to the disclosures made and the supporting documentation. The SEC Is Not “Targeting„ Banks. Some have suggested that the SEC is “targeting„ banks or has a specialized program aimed at banks’ loan loss allowances. To the contrary, the SEC has the same process for selecting and reviewing filings by banks as it does for filings of all public companies. We have not altered that process as it applies to banks. Our process for reviewing filings of public companies, including the filings of financial institutions, is as follows. Registration statements, proxy statements, and periodic reports filed with the Commission under the federal securities laws are reviewed by staff in the Division of Corporation Finance (for entities other than investment advisers and investment companies). The review of filed documents is intended to determine, among other things, whether any material questions exist regarding: (a) the adequacy of the disclosure made; (b) conformity of the financial data and other disclosures with the requirements for the form and content of financial statements; (c) whether such data are presented in conformity with GAAP; (d) whether the financial statements are audited by independent accountants; and (e) whether there appear to be any material inconsistencies between financial information and other disclosures made. Not all filings are subjected to a full review every year. The Division of Corporation Finance performs a full review of virtually all filings relating to an initial public offering, and selects the filings of other registrants based on confidential selective review criteria. The selective review criteria are kept confidential in order to protect the integrity and effectiveness of the review process. Once selected for review, a particular filing will be assigned to a review team composed of accountants and attorneys who specialize in the industry group of the particular company. The staff may develop a comment letter that identifies areas that require further informal explanation to the staff or may require that the issuer make changes through an amended filing. The review process often involves exchanges of correspondence, supplemental supporting documents, and face-to-face meetings. The vast majority of issues are resolved during the staff’s review process. If, however, as part of the review process or from some other source, the staff becomes aware of a noncompliance with GAAP that makes the financial statements materially misleading to investors, then the staff will consider the courses of action available to it under the federal securities laws[20].[21] THE SEC REQUIRES TRANSPARENCY IN FINANCIAL STATEMENTS All Public Companies Must Provide Transparent Disclosures That Explain Financial Results. Because the SEC’s mandate is to protect investors through full and fair disclosure, it is not surprising that after reviewing financial statements of public companies, including banks, the SEC staff may request additional disclosures. While the SEC staff routinely asks banks for clarification of their loan loss allowance disclosures,[22] challenge of management’s determination of a loan loss allowance by the staff is very unusual. Where statistical data, quantitative analysis, or disclosures in the filing appear inconsistent with loan loss provisions or allowances, the staff will ask the company to explain those inconsistencies. For example, data commonly used to evaluate the appropriateness of the loan loss allowance may indicate an inconsistency between the accounting for the allowance and the disclosure of material risks in the portfolio for which the allowance was maintained. In such a case, the staff may issue comments on the filing relating to the loan loss allowance.[23] The disclosures in filings with the Commission should be consistent with the documentation supporting the adequacy of the allowance. In a few cases, inconsistencies in disclosure led the staff to discover that the internal supporting documentation and analyses were inconsistent with the amount recorded in the allowance for loan losses. We recognize that judgment is required in arriving at a reasonable range of probable credit losses. Nevertheless, documentation must clearly support the reported allowance. As William J. McDonough, president of the Federal Reserve Bank of New York recently commented: “You should insist banks have a rationale . . . and that there is a paper trail on how you get to that judgment [about the amount of the allowance].„[24] Disclosure and documentation issues noted by the staff include: (i) instances where disclosures did not describe the methodology used by the bank to calculate allowances;[25] (ii) instances where the bank did not explain the reasons for changes in the loan loss allowance in a way that helped investors understand how risks in the loan portfolio impact earnings and the amount of the loan loss allowance; (iii) instances where disclosures in the financial statements and elsewhere in the filing appear inconsistent with the amount recorded in the allowance for loan losses; and (iv) instances where allowances were in excess of the range of documented credit losses inherent in the portfolio.[26] The issues noted in the preceding paragraph typically have been resolved by the bank clarifying the disclosures in its filing. [27] In those relatively rare cases where the inconsistency between the disclosure and the financial statements could be corrected only by a restatement of the financial statements, and a significant policy issue was involved, the SEC staff conferred with the bank agencies prior to asking for the restatement. In the past three years, the SEC staff has not pursued enforcement action against a bank based on noncompliance with the accounting for the allowance for loan losses[28].[29] Perhaps the statement most responsive to the staff’s disclosure, documentation, and accounting concerns is contained in the November Joint Statement: Although management’s process for determining allowance adequacy is judgmental and results in a range of estimated losses, it must not be used to manipulate earnings or mislead investors, funds providers, regulators or other affected parties. Management’s process must be based on a comprehensive, adequately documented, and consistently applied analysis of the institution’s loan portfolio. The depository institution must ensure that its allowance is supportable in light of the accompanying disclosures made to investors, including those made in management’s discussion and analysis and financial footnotes, with respect to the underlying economics and trends in the portfolio and any other factors that significantly affect the collectibility of loans.[30] Accounting for Loan Losses Must Be in Accordance with GAAP. Under the federal securities laws, public companies must comply with GAAP. The primary sources of GAAP for loans and the allowance for loan losses are FASB Statement Nos. 5 and 114.[31] Statement 5 establishes the fundamental recognition guidance for losses: losses should be recognized[32] when it is probable that they have been incurred as of the date being reported on, and the amount of loss can be reliably measured. Statement 114 expands on the guidance in Statement 5 as it applies to individual, specifically evaluated, loans (as opposed to portfolios of loans). This guidance is supplemented by the American Institute of Certified Public Accountants (“AICPA„) Audit and Accounting Guide for Banks and Savings Institutions[33] and FRR 28, along with other sources. We recognize that certain aspects of GAAP require further clarification. For example, we recognize that it may be difficult to distinguish probable losses inherent in the loan portfolio as of the balance sheet date from possible or future losses not inherent in the portfolio as of that date. That is why, as discussed below, the SEC and banking agencies have formed a Joint Working Group to work on a number of initiatives and have agreed to support the AICPA task force that will be providing guidance on that issue. The joint initiatives are underway, and are expected to “promote a better and clearer understanding among financial institutions of the appropriate procedures and processes for determining credit losses in accordance with GAAP.„[34] In addition, we encourage financial institutions and others to bring to our attention points that still require clarification.[35] The SEC Relies on an Independent Private Sector Standards- Setting Process that Is Thorough, Open, and Deliberative. The strength of our accounting standards is derived from the independent private sector standards-setting process, as overseen by the SEC. Private sector standards setting in accounting is a model that works and offers proof that private sector initiatives with governmental oversight can be successful. The primary private sector standards setter is the FASB,[36] and FASB statements are designated as a primary level of GAAP.[37] For over 60 years, the Commission has looked to the private sector to set accounting standards. While the Commission can set accounting principles,[38] since 1938, we have long recognized the expertise, energy, and resources that the private sector can bring to bear on complex accounting issues.[39] Again, as FRB Chairman Greenspan noted, “The success of the U.S. accounting model has been due, in no small part, to the private sector’s significant involvement in the process.„[40] FASB was established in 1972. The members of the FASB are appointed by an oversight body representing its core constituency of investors, business people, and accountants. In setting standards, the FASB follows a thorough, open, and deliberative process. For major projects, that process can include: (i) wide distribution of discussion memoranda; (ii) public hearings; (iii) publication of exposure drafts; (iv) solicitation of comment letters; (v) public deliberation on comment letters; and (vi) use of field tests to test standards before their adoption. The SEC oversees the FASB and its accounting standards- setting process. Specifically, the SEC staff evaluates each project and proposed standard to make sure that the FASB process is operating in an open, fair, and impartial manner, and that each standard adopted is within an acceptable range of alternatives that serve the public interest and protect investors. The SEC staff: (i) monitors FASB project developments; (ii) meets with the FASB and its staff on a regular basis to discuss pending FASB projects; (iii) reviews comment letters received by the FASB on its projects; and (iv) after a standard is adopted, continues to consult with the FASB staff on implementation issues. COOPERATIVE EFFORTS OF THE SEC AND BANKING AGENCIES The SEC and the banking agencies have been working together to address their concerns about allowances for loan losses.[41] Our initiatives to date, which are discussed below, have produced two joint letters outlining areas of agreement and initiatives that the agencies agree to undertake in the area of allowances for loan losses. November 1998 Joint Interagency Statement. As noted above, the SEC, FDIC, FRB, OCC, and OTS issued the November Joint Statement to “better ensure the consistent application of loan loss accounting policy and to improve the transparency of financial statements.„[42] In the November Joint Statement, the agencies recognized “the importance of meaningful financial statements and disclosure for both the benefit of investors and a safe and sound financial system.„[43] The SEC and banking agencies agreed on certain principles relating to loan loss allowances. Some of these principles are: (i) FRR 28 and a 1993 Joint Interagency Policy Statement on the Allowance for Loan and Lease Losses,[44] which provide guidance on the establishment and maintenance of an allowance consistent with GAAP, should be considered in determining loan loss allowances; (ii) management’s judgment should be exercised in a disciplined manner that is based on and reflective of adequate detailed analyses of the loan portfolio; (iii) management’s process for determining allowance adequacy is judgmental and results in a range of estimated losses, but cannot be used to manipulate earnings or mislead investors; and (iv) management’s process must be based on a comprehensive, adequately documented, and consistently applied analysis of the institution’s loan portfolio, and the allowance must be supportable in light of the accompanying disclosures.[45] March 1999 Joint Interagency Letter. Ongoing discussions with the banking agencies and continued uncertainty among financial institutions led to the March Joint Letter. This letter reaffirmed certain principles agreed to in the November Joint Statement and announced new initiatives regarding loan loss allowances. The initiatives are intended to “enhance the transparency of financial information and improve market discipline, consistent with safety and soundness objectives.„[46] The SEC and banking agencies agreed to: (i) form a Joint Working Group, composed of representatives of each of the agencies, to better understand sound practices used generally by financial institutions to determine the allowance for credit losses; (ii) use the knowledge gained through the Joint Working Group to develop enhanced guidance on appropriate methodologies, disclosures, and supporting documentation for loan loss allowances; (iii) encourage and support the FASB’s process of providing additional guidance regarding accounting for allowances for loan losses; and (iv) support and encourage the AICPA’s task force that is developing more specific guidance on the accounting for allowances for credit losses and the techniques for measuring credit losses inherent in a portfolio at a particular date. Additional Guidance from the FASB. As noted, the SEC and banking agencies agreed to support the FASB’s process of providing additional guidance regarding the accounting for allowances for loan losses. On April 12, 1999, the FASB staff issued a Viewpoints article that represents such additional guidance.[47] The guidance in the Viewpoints article describes the requirements of FASB Statement Nos. 5 and 114. The purpose of the article is to clarify how the FASB intended these existing standards to be applied by entities, and to answer questions that the FASB staff had received from the SEC, banking agencies, and others regarding the detailed application of Statements 5 and 114 to a loan portfolio.[48] The guidance included in the article was circulated in draft form to numerous interested parties. We understand that, among others, it was circulated in draft to members of the banking agencies, the FASB’s Emerging Issues Task Force (“EITF„),[49] the AICPA’s Allowance for Loan Loss Task Force,[50] and the SEC staff. After issuance of the article, a number of accountants and others asked the SEC staff whether financial institutions would have to restate their prior financial statements in response to the Viewpoints article if changes to allowance measurements were necessary. The staff’s response was measured -- if such adjustments were necessary, we would not require restatement of prior year financial statements because the SEC and banking agencies had agreed in the March Joint Letter to focus on enhancing allowance practices prospectively, to the extent feasible. The SEC staff stated that it would not deem past practice to have been in error. Rather, the staff indicated that affected registrants could provide a one-time adjustment to their financial statements. Of course, those banks whose allowances already followed FASB Statement Nos. 5 and 114 and the guidance in the article would not need to take any action. The staff’s guidance took the form of a letter to the FASB’s EITF on May 20, 1999.[51] Prior to being issued, this letter was circulated in draft form for comment to the banking agencies and others, including industry representatives. The staff modified the initial draft based on the comments received. On May 21, 1999, the FRB circulated a letter to each of its member banks and banking organizations addressing the FASB’s Viewpoints article.[52] The FRB reiterated that institutions that it supervises should use GAAP to account for loan loss allowances and “should consider the FASB guidance . . . in developing their allowance estimates.„[53] The FRB noted that it did not expect the FASB guidance to have more than a limited impact on loan loss allowance levels.[54] The letter also highlighted points of agreement reached between the SEC and the FRB with respect to allowance practices. May 24 and June 14 Letters. Chairman Levitt voiced the Commission’s full support, in a letter dated May 24, 1999, for the basic concepts[55] in the FRB letter.[56] He expressed the Commission’s intention to continue working closely with the FRB and the other banking agencies toward the goals of transparency and safety and soundness. Chairman Levitt also clarified certain areas of misunderstanding by stating that the SEC has no policy of asking banks to artificially lower their loan allowances and that we do not take any positions on banks’ credit policies. He said, “The SEC’s views are predicated on the belief that the most effective form of oversight comes from an informed market place. Other than these concerns on transparency, neither GAAP nor the SEC takes a position on credit policies.„[57] Chairman Levitt also noted that the SEC’s position is consistent with the statement in the FRB letter that, “‘the important consideration is whether the allowance reflects an estimate of probable losses, determined in accordance with GAAP, and is appropriately supported.’„[58] As recently as June 14, 1999, our Chief Accountant encouraged financial institutions to look to the fundamental concepts identified by the FRB staff in their May 21 letter. Those concepts include: (I) a high degree of management judgment is required in the determination of an appropriate loan loss allowance; (ii) the estimate of loan losses is inevitably imprecise and may fall within a range of estimated losses. In accordance with GAAP an institution should record its best estimate within the range of credit losses, including when management’s best estimate is at the high end of the range; (iii) an “unallocated„ loan loss allowance is appropriate if it reflects an estimate of probable losses, determined in accordance with GAAP, and is appropriately supported; (iv) allowance estimates should be based on a comprehensive, well-documented, and consistently applied analysis of the loan portfolio; and (v) the loan loss allowance should take into consideration all available information existing as of the financial statement date, including environmental factors such as industry, geographical, economic and, political factors. ONGOING EFFORTS REGARDING ALLOWANCES FOR LOAN LOSSES Since the issuance of the March Joint Letter, the SEC staff has had ongoing discussions with the banking agencies with respect to loan loss allowances, and we are working together on many of the issues. For example, the staff of the agencies set up two sub-groups of the Joint Working Group to work toward the issuance of parallel guidance on disclosure and documentation related to loan loss allowances. Through the sub-groups, the staffs of the agencies have met seven times and have drafted a plan for achieving the agreed upon goals, consistent with the March Joint Letter. In addition, both the SEC staff and the banking agencies have an observer that attends the meetings of the AICPA Allowance for Loan Loss Task Force. The Task Force has met four times and has developed a prospectus that outlines the scope and objectives of its project, which will be reviewed by the FASB.[59] Importantly, the agencies continue to hold meetings involving senior staff to discuss banking industry accounting and financial disclosure policy issues of interest. In our view, the agencies have shown in the past that we can work together in a constructive and cooperative manner on this issue. We realize that it is in none of our interests for the banking industry to be caught in a crossfire between regulators. Accordingly, we intend to continue to coordinate our efforts to ensure that all financial reporting policies serve the needs of investors, our financial markets, and the public interest. Thank you for the opportunity for the Commission to appear here today. I would be happy to answer any questions that you may have. **FOOTNOTES** [1]: We use the terms “banks„ and “financial institutions„ interchangeably to include banks, bank holding companies, thrifts, and other types of institutions that operate under the supervision of the Federal Deposit Insurance Corporation (“FDIC„), the Federal Reserve Board (“FRB„), the Office of the Comptroller of the Currency (“OCC„), or the Office of Thrift Supervision (“OTS„), and which are public companies under the jurisdiction of the SEC. [2]: As discussed below, as recently as Monday, June 14, 1999, for example, the SEC’s Chief Accountant, Lynn Turner, outlined points of agreement between the SEC and the FRB with respect to financial institutions’ development of estimates of loan loss allowances for financial reporting purposes. Letter from Lynn E. Turner, SEC, Chief Accountant, to Richard Spillenkothen, Director - Division of Banking Supervision and Regulation, FRB (June 14, 1999) [3]: Arthur Levitt, Chairman, SEC, An Address to the Committee for Economic Development (May 19, 1999). [4]: Letter from Alan Greenspan, Chairman, FRB, to Arthur Levitt, Chairman, SEC (June 4, 1998). [5]: Joint Interagency Letter to Financial Institutions from the SEC, FDIC, FRB, OCC, and OTS (Mar. 10, 1999) [hereinafter “March Joint Letter„]. [6]: See “And it finally came to tears,„ Economist, Nov. 29, 1997, at 77, 78. (“Thirteen of the 19 biggest [Japanese] banks expect to report losses this year as a result of writing off bad loans. This week several big banks claimed yet again that the worst of their bad debt problems are behind them. Given the opacity of the banks’ accounting, however, the markets do not trust this.„). [7]: Basle Committee on Banking Supervision, “Enhancing Bank Transparency,„ para. 4 (Sept. 1998). [8]: See “And it finally came to tears,„ Economist, Nov. 29, 1997, at 77, 78. [9]: See March Joint Letter, supra note 5. [10]: This was achieved by modifying GAAP results to delay the recognition in earnings of losses on assets sold while accelerating the recognition in earnings of certain fees. In addition, certain unrealized gains on appreciated assets were included to meet capital requirements, while the decrease in value of other assets was not. See generally Testimony of Richard C. Breeden, Chairman, SEC, Concerning Issues Involving Financial Institutions and Accounting Principles Before the Senate Comm. on Banking, Housing and Urban Affairs (Sept. 10, 1990). [11]: Pub. L. No. 102-242, 105 Stat. 2236 (1991). [12]: Section 37(a)(1) of the Federal Deposit Insurance Act (“FDIA„), 12 U.S.C. ( 1831n(a)(1). [13]: Section 37(a)(2)(A) of the FDIA, 12 U.S.C. ( 1831n(a)(2)(A). FDIA permits banking agencies to require banks to report more stringent loan loss allowances for regulatory purposes than would be determined under GAAP. However, banks would still be required to file financial statements with the SEC that are prepared in accordance with GAAP. [14]: The allowance for loan losses does not protect banks from loan losses; the allowance is an accounting device. Capital is not the same as allowances. The cushion against possible future losses -- that is, the ability to remain solvent when confronted with significant losses -- is provided by capital (generally, the excess of assets over liabilities). To make sure that the bank will remain “safe and sound,„ the banking agencies have established regulations to ensure that financial institutions maintain sufficient capital and liquidity. The allowance for loan losses, on the other hand, is an accounting estimate of the probable amount of loans that will not be repaid to the bank based on current events. For example, a loan loss allowance of $2, with total loans to the bank’s customers of $100, tells the reader of the financial statements that, as of the date of the financial statements (e.g., December 31, 1998), management believes, based on the facts at December 31, 1998, that the bank will collect only $98, not $100. [15]: United States General Accounting Office (“GAO„), Report to Congress on “Depository Institutions: Divergent Loan Loss Methods Undermine Usefulness of Financial Reports,„ 3 (Oct. 1994) [hereinafter “GAO Report„]. [16]: Id. at 5. See also OCC, Advisory Letter 97-8, “Allowance for Loan and Lease Losses„ (Aug. 6, 1997) (“Unallocated reserves . . . must not be used to obfuscate the determination of the overall allowance adequacy, mask significant deteriorating trends in asset quality, or ‘manage’ earnings.„) [17]: See Joint Interagency Statement by the SEC, FDIC, FRB, OCC, and OTS (Nov. 24, 1998) [hereinafter the “November Joint Statement„] (“management’s process for determining allowance adequacy is judgmental„); “Accounting for Loan Losses by Registrants Engaged in Lending Activities,„ Financial Reporting Release No. 28 (Dec. 1, 1986) [hereinafter “FRR 28„] (“[a]rriving at an appropriate reported allowance for loan losses necessarily involves a high degree of management judgment„). [18]: See March Joint Letter, supra note 5. [19]: Item 303 of Regulation S-K, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,„ and Regulation S-B, “Management’s Discussion and Analysis or Plan of Operation.„ Simply put, Item 303 requires a narrative explanation of the financial statements as they appear through the eyes of management. [20]: [21]: For example, the staff has recommended that the Commission bring enforcement actions when the staff believed registrants were engaging in attempts to manage reported earnings in a manner inconsistent with GAAP. For actions against non-bank registrants and management accountants, see, e.g., In the Matter of Terex Corp., Accounting and Auditing Enforcement Release No. (“AAER„) 1126 (Apr. 20, 1999); In the Matter of Sunrise Medical Inc., AAER 1110 (Feb. 24, 1999); In the Matter of Donkenny Inc., AAER 1104 (Feb. 2, 1999); In the Matter of Livent, AAER 1095 (Jan. 13, 1999); In the Matter of Sensormatic Electronics Corporation, AAER 1017 (Mar. 25, 1998); and SEC v. W.R. Grace & Co., Litigation Release No. 16008 (Dec. 22, 1998). For cases against auditors of registrants engaging in “earnings management„ through inappropriate revenue recognition practices, see, e.g., In the Matter of Paul G. Mount, AAER 1010 (Jan. 30, 1998); In the Matter of Philip S. Present, AAER 904 (Apr. 10, 1997); and In the Matter of Peter C. Ferraro, AAER 804 (July 24, 1996). [22]: More than 900 bank or thrift holding companies file annual reports with the Commission. In that industry, in calendar year 1997, we reviewed 104 registration statements involving mergers, 81 other registration statements, and 227 Form 10- Ks. In 1998, we reviewed 62 merger-related registration statements, 119 other registration statements, and 157 Form 10-Ks. So far in 1999, we have reviewed 24 merger-related registration statements, 39 other registration statements, and 88 Form 10-Ks. We do not routinely track specific categories of comments, but we estimate that between 30 and 50 percent of the letters issued in each of those years included at least one comment relating to loan loss accounting or disclosure. We believe that a similar proportion of our letters to finance companies, which are not regulated by the banking agencies, contain comments relating to loan loss accounting or disclosure. [23]: In addition to commenting on specific filings, our staff sent two sets of letters to a handful of bank holding companies, selected based on review criteria, reminding them of the disclosures currently required by GAAP and SEC regulations. The staff also made the letters available on its website (www.sec.gov). One letter addressed disclosures for allowances and the other addressed disclosures for public companies, including banks, that were reporting certain types of significant charges (for asset write-downs and restructuring activities). [24]: Debra Cope “N.Y. Fed Chief Urges Better System for Loan Reserves,„ Amer. Banker. Mar. 19, 1999, at 1. [25]: See FRR 28, supra note 17. FRR 28 requires the application of a systematic methodology and rationale in determining the allowance for loan losses. [26]: We note that concerns about allowance disclosures and practices are not peculiar to the banking industry. We recently brought enforcement cases against other types of public companies that have inappropriately valued the probable losses of the company. See, e.g., In the Matter of Lee Pharmaceuticals, AAER 1023 (Apr. 9, 1998) (Lee Pharmaceuticals materially understated its environmental liabilities). [27]: You have inquired as to whether the SEC has coordinated its comments to banks with the banking agencies. Generally, the staff’s comment process addresses established disclosure obligations under the federal securities laws. Issues identified in the staff’s comments often are resolved in the course of the comment process, which may or may not result in amended filings. The staff typically follows its normal procedures for issuing such comment letters and does not coordinate its routine process with the banking agencies. When the staff’s review process has uncovered accounting issues on which the banking agencies may be able to provide insight, the staff has consulted with them. [28]: [29]: The Commission has, however, initiated enforcement actions in past years -- when to do so was necessary and appropriate to protect investors -- for example, when financial institutions did not have systems in place to determine the losses inherent in their loan portfolios (see, e.g., SEC v. Financial Corporation of America, AAER 153 (Sept. 21, 1987); In the Matter of Texas Commerce Bancshares, Inc., AAER 146 (Aug. 17, 1987); In the Matter of First Chicago Corporation, AAER 134 (June 10, 1987); and In the Matter of Continental Illinois Corp., AAER 128 (Feb. 27, 1987)); when financial institutions did not consider negative trends and regional economic conditions when establishing allowances for loan losses (see, e.g., SEC v. Aulie, AAER 305 (July 9, 1991), regarding Brooklyn Savings Bank; and SEC v. Bank of New England, AAER 286 (Dec. 21, 1990)); and when the allowance for loan losses did not reflect losses inherent in the loan portfolio (see, e.g., SEC v. Gary L. Holman, AAER 756 (Feb. 1, 1996) regarding Homestead Holding Corporation; SEC v. Morris, AAER 545 (March 31, 1994) regarding Germania Bank; and In the Matter of Richard R. Swann, AAER 525 (Feb. 1, 1994) regarding American Pioneer Savings Bank ). [30]: See November Joint Statement, supra note 17. [31]: Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies„ (Mar. 1975); and Statement of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan„ (May 1993). [32]: The accounting requirements distinguish between recognition and disclosure. Specific guidance exists for most transactions that indicates when an event is to be measured and reported in the balance sheet and profit and loss statement -- that is, recognized -- and when it should be disclosed solely in the notes to the financial statements -- that is, disclosed. Statement 5 specifies the threshold for a loss event to be recognized and the circumstances in which disclosure alone is required. [33]: As summarized in the Audit Guide, “The allowance for loan losses should be adequate to cover probable credit losses related to specifically identified loans as well as probable credit losses inherent in the remainder of the loan portfolio that have been incurred as of the balance sheet date.„ AICPA Audit and Accounting Guide, “Banks and Savings Institutions,„ ch. 7 (May 1998). [34]: See March Joint Letter, supra note 5. [35]: You have inquired about the steps the SEC has taken and will take to resolve confusion surrounding loan loss issues. In an effort to bring additional clarity to this issue, Chairman Levitt has spoken on this topic, as have members of the SEC staff. These speeches are in addition to our ongoing collaborative efforts with the banking agencies, our support of the FASB and AICPA processes to develop additional guidance, and our discussions with financial institutions and others. [36]: Statement of Policy on the Establishment and Improvement of Accounting Principles and Standards, Accounting Series Release (“ASR„) 150 (Dec. 20, 1973). [37]: AICPA, Statement on Auditing Standards No. 69, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles in the Independent Auditor’s Report,„ para. 10(a) (Mar. 1992). Rule 4-01(a)(1) of Regulation S-X, 17 CFR ( 210.4-01, provides that financial statements filed with the Commission that are not prepared in accordance with GAAP will be presumed to be misleading unless the Commission has found otherwise. [38]: Specifically, the Commission may prescribe the form in which financial information filed with the Commission shall be set forth, the items to be shown in the balance sheet and the income statement, and the methods to be followed, and may define accounting terms. See, e.g., (( 7 and 19(a) (15 U.S.C. (( 77g, 77s(a)) and items (25), (26), and (27) of Schedule A of the Securities Act of 1933, and (( 3(b), 12, 13(b)(1) and 17(e)(2) of the Securities Exchange Act of 1934 (15 U.S.C. (( 78c(b), 78l, 78m(b)(1), 78q(e)(2)). [39]: Administrative policy on financial statements, ASR No. 4 (Apr. 4, 1938). While the Commission looks to the private sector for standard setting, the Commission also maintains its own accounting regulations, which often serve to supplement the FASB’s pronouncements for Commission registrants. [40]: Letter from Alan Greenspan, Chairman, FRB, to Arthur Levitt, Chairman, SEC (June 4, 1998). [41]: The SEC has a long history of working and consulting with the banking agencies on accounting and disclosure issues of mutual interest. In recent years, the SEC and the banking agencies have held meetings to discuss issues such as marketable securities, market risk disclosures, and auditor independence matters. The staff has also frequently conferred with representatives of the banking agencies informally through telephone conversations. When the banking agencies issued a 1993 Joint Interagency Policy Statement, the SEC staff reviewed a draft of the statement and provided comments. Queries from the Office of the Superintendent of Financial Institutions Canada, in mid-1997, focused the staff's attention on certain changes in statistical ratios of banks loans, losses and allowances. In February 1998, and again in October 1998, the SEC and the banking agencies met to discuss these issues. [42]: November Joint Statement, supra note 17. [43]: Id. [44]: Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL), by the OCC, FDIC, FRB, and OTS (Dec. 21, 1993). [45]: See generally, November Joint Statement, supra note 17. [46]: March Joint Letter, supra note 5. [47]: FASB Viewpoints, “Application of FASB Statements 5 and 114 to a Loan Portfolio„ (Apr. 12, 1999). [48]: You inquired as to whether the SEC views the Viewpoints article as a material change to GAAP and about its potential impact. As we stated above, we view the Viewpoints article as an effort by the FASB staff to clarify how companies should apply existing GAAP in FASB Statement Nos. 5 and 114, which were issued in 1975 and 1993, respectively. As to the impact of the Viewpoints article, we are not in a position to draw any definitive conclusions, and, as we stated in our May 20, 1999 staff announcement at the EITF, the staff has no views as to whether this will represent a significant change in current practice. The FRB has stated that it expects that the recent guidance "will have only a limited impact on allowance levels in the industry." Letter from Richard Spillenkothen, Director, FRB, to the Officer in Charge of Supervision and Appropriate Supervisory and Examination Staff at Each Federal Reserve Bank and to Domestic Banking Organizations Supervised by the Federal Reserve (May 21, 1999) [hereinafter “Spillenkothen Letter„]. [49]: The EITF is composed of 13 members -- nine members are from accounting firms, two members are banking industry representatives, and two members are from other industries. [50]: The AICPA Allowance for Loan Loss Task Force is composed of eight members -- five members are from accounting firms, two members are banking industry representatives, and one member is a former employee of the GAO. [51]: Letter from Lynn Turner, Chief Accountant, SEC, to Timothy Lucas, FASB’s EITF (May 20, 1999). [52]: Spillenkothen Letter, supra note 46. [53]: Id. [54]: Id. [55]: One such important concept is the need for institutions to take into account all available information existing as of the financial statement date, including current trends and existing “environmental„ factors (such as industry, geographical, economic, and political factors). [56]: Letter from Arthur Levitt, Chairman, SEC, to Governor Laurence H. Meyer, FRB (May 24, 1999). [57]: Id. [58]: Id. [59]: One of the important objectives outlined in the AICPA Task Force’s prospectus is to focus on providing guidance on how best to distinguish probable losses inherent in the portfolio as of the balance sheet date from possible or future losses not inherent in the portfolio as of that date.