Depository Institutions

Divergent Loan Loss Methods Undermine Usefulness of Financial Reports Gao ID: AIMD-95-8 October 31, 1994

Loan loss reserves are a major indicator of a depository institution's loss exposure from problem loans and are critical to understanding the entity's financial condition. From 1980 to 1992, about 2,700 federally insured institutions failed, at a substantial cost to taxpayers and the insurance funds. Loan losses were the major cause of many of these failures. Past GAO reports have shown that institutions have made inadequate estimates of loan losses prior to failure and that regulatory examiners have lacked a consistent framework to quantify loan portfolio risks and assess reserve adequacy. This report presents the results of GAO's review of the methods used by federally insured depository institutions to establish loss reserves for loans that are likely to be uncollectible. Neither authoritative accounting standards nor regulatory guidance provide sufficiently detailed direction to depository institutions for establishment of loan loss reserves. As a result, institutions used widely diverse methods that produced reserves that could not be meaningfully compared among such institutions and may not have reflected the true loss exposure in the institutions' loan portfolios.

GAO found that: (1) case studies showed that the depository institutions maintained significant amounts of unsupported loan loss reserves, particularly large supplemental reserves that were not linked to loss exposure; (2) most of the institutions' loan loss reserves were not justified by supporting analysis and were not comparable among institutions; (3) the institutions' reserving methods varied greatly regarding the use of individual loan assessment results, determination and use of historical loss experience, and the inclusion of supplemental reserves; (4) financial report users could not compare the adequacy of the institutions' reserves or judge the quality of their loan portfolios; (5) unjustified supplemental reserves could cushion changes in the condition of the loan portfolio and mask the institutions' true financial status, which in turn could impede regulators' oversight; and (6) there was no regulatory guidance for establishing loan loss reserves, which gave the institutions excessive flexibility in how they calculated their loss reserves.


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