Chairman Grams, Senator Dodd, 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, the SEC's interaction with financial institutions,(1) and most importantly, the critical progress that has been and continues to be made by the SEC and the banking agencies in addressing areas of concern to all of us.
We recognize that there have been concerns expressed, including from members of this Subcommittee and others in Congress, about how the SEC and the banking agencies are coordinating their efforts to address loan loss allowance issues. We have heard your concerns. I believe that the SEC and the banking agencies have made great progress in addressing these concerns, and today, the banks are receiving better guidance -- in terms of the proper application of GAAP and the need for appropriate documentation and disclosure -- than ever before. The joint agreements and coordinated efforts of the agencies provide a solid foundation from which we can move forward and build further consensus on these important issues.
Since November 1998, the SEC and the banking agencies have entered into three joint interagency agreements (2)regarding loan loss allowances. These agreements note important areas of consensus and clarify areas that may have been misunderstood. The staffs of the agencies have met approximately 12 times since November to discuss loan loss allowance issues, and in March, the staffs of the agencies formed a Joint Working Group to work toward the issuance of parallel guidance on disclosure and documentation issues related to loan loss allowances. The senior staff of the agencies continue to have mutually helpful and constructive discussions on these issues.
Most recently, and since last month's hearing before the Subcommittee on Financial Institutions and Consumer Credit of the House Banking and Financial Services Committee,(3)the SEC, FDIC, FRB, OCC and OTS issued the July Joint Letter. In the July Joint Letter, the agencies agreed on important aspects of loan loss allowance practices, and agreed to:
continue to cooperate and communicate with respect to significant issues of policy through their Chief Accountants' meetings. In addition, the SEC staff will consult with the appropriate banking regulators as part of the SEC's process in determining whether to take a significant action in their review of the accounting for a financial institution's loan loss allowance.
The three joint interagency letters -- and particularly the July Joint Letter -- make quite clear the SEC's willingness and commitment to consult with the banking agencies on significant loan loss accounting issues raised during the SEC's review of a financial institution's filing.
We note in this regard that a recent amendment to H.R. 10(4) requiring SEC coordination and consultation by the SEC with the banking regulators on comment letters by the SEC is unnecessary and, as currently drafted, would add significant delays to the processing of banks' disclosure documents and create additional costs for banks seeking to raise capital in U.S. markets. As discussed below, many of the SEC's comment letters to public companies, including financial institutions, are routine and are resolved quickly through discussions with the institution on an informal basis or by the institution providing clarifying disclosure in its filings. Requiring consultation on each and every one of the SEC staff's comment letters would have significant counterproductive effects.(5)
I should emphasize that in the past the SEC staff has in fact consulted with the primary banking agency when a significant issue has been raised during the staff's review of an institution's loan loss allowance.(6) The July Joint Letter reaffirms our commitment to continue to do so and, going forward, to consult with all appropriate banking agencies under such circumstances. Accordingly, we do not think legislation in this area is necessary.(7)
Each of the agreements with the banking agencies and the coordinated efforts of the staffs reflect the strong commitment of the SEC to the activities and initiatives agreed upon among the agencies. The progress to date has been great, and in my view, represents good government at work. I fully expect these cooperative efforts to continue.
BACKGROUND ON THE NEED FOR TRANSPARENT FINANCIAL REPORTING
Transparent Financial Reporting Protects the Financial Markets In general, the goal of the SEC's disclosure system is to promote honest and efficient markets and informed investment decisions through full and fair disclosure. 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 boards of directors to evaluate management's effectiveness, and to take early corrective actions, when necessary, to address deterioration in the financial condition of the companies or banks.
Therefore, it is critical that all public companies, including financial institutions, provide a comprehensive and reliable portrayal of their financial condition and performance. Recent events in the world's markets(8) have been painful reminders of what can happen when investors and regulators do not have a comprehensive and reliable picture of businesses. With transparency in financial reports, there are no surprises.
Transparency of Allowances for Loan Losses Is Needed Loans are the largest component of most financial institution's assets. Allowances 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 important 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. In such cases, the financial statements of financial institutions would not reflect actual losses in the institutions' loan portfolios on a timely basis. Investors, regulators, and others would not have a reliable gauge of the credit losses 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. (9) 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 possibly to the system as a whole.
Concerns about loan loss allowances are not new to any of us. Nearly five years ago, the GAO warned us about the continuing problem of inappropriate accounting for allowances and the resulting harm. 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. (10)
The SEC became concerned about loan loss allowances in mid-1997 when Canadian regulators and others inquired about loan loss allowances of U.S. financial institutions. These concerns pre-dated our recent focus on "earnings management." (11) Our concerns were expressed publicly by the previous SEC Chief Accountant in November 1997,(12) and in February and October 1998, the SEC met with the banking agencies to discuss these concerns. The earnings management issue is a related but distinct issue. While we have brought a number of cases against corporate issuers for earnings management, the Commission has not brought any enforcement action against a financial institution in the past year for earnings management involving excessive loan loss allowances.
GAAP Provides Transparency, Consistency, and Comparability Investors, regulators, and creditors expect reliable, consistent, comparable, and transparent 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 standards and comparable practices are necessary. Such standards and practices must be applied in a like manner by companies in like circumstances. Generally Accepted Accounting Principles (GAAP) are the backbone of transparent financial reporting.
GAAP is the framework for the accounting -- that is, the recognition, measurement, and disclosure -- required for the issuance of securities and financial reporting of all public companies, including financial institutions. In a joint interagency letter, dated March 10, 1999, (13) and in the recent July Joint Letter, the banking agencies and the SEC reaffirmed the policy set by Congress that financial institutions should follow GAAP.
The Importance of the Private Sector Standards-Setting Process
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. The primary private sector standards setter is the Financial Accounting Standards Board (FASB), (14) and FASB statements are designated as the primary level of GAAP. (15)
Private sector standards setting in accounting is a model that works and offers proof that private sector initiatives with governmental oversight can be successful. 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 or [sic] 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. (16)
For over 60 years, the Commission has looked to the private sector to set accounting standards. While the Commission can set accounting principles, since 1938, we have recognized the expertise, energy, and resources that the private sector can bring to bear on complex accounting issues. (17) 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." (18)
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.
Recent Guidance from the FASB Staff. The SEC and banking agencies agreed in the March Joint Letter 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 Q&A article that represents such additional guidance.(19) In the July Joint Letter, the SEC and banking agencies agreed that financial institutions should follow that guidance.
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.
The SEC Is Not Requiring Banks to Artificially Lower Allowances; GAAP Is Required Some have suggested that as a result of reviewing loan loss allowances in filings by financial institutions, the SEC is requiring all banks to reduce their allowances. That is simply not true. To be clear, the SEC does not want, nor has it ever wanted, financial institutions to artificially lower loan allowances or ever have inadequate allowances. As I stated on May 19th and reiterate today:
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.(20)
The SEC Is Not "Targeting" Banks. Some have suggested that the SEC is "targeting" banks. 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. The basic SEC process for reviewing filings of public companies, including the filings of financial institutions, is as follows.
The SEC's Review Process for All Public Companies. 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. (21)
While the SEC staff routinely asks banks for clarification of their loan loss allowance disclosures, challenge of management's determination of a loan loss allowance by the staff is very unusual. Issues that arise in the review process typically have been resolved on an informal basis. 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 primary banking agency prior to asking for the restatement.
ONGOING EFFORTS REGARDING ALLOWANCES FOR LOAN LOSSES
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. As noted above, the SEC and the banking agencies have entered into three joint interagency agreements.
The staffs of the agencies set up two sub-groups of a 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 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's Allowance for Loan Losses Task Force. The Task Force has met approximately 6 times and has developed a prospectus that outlines the scope and objectives of its project, which will be reviewed by the FASB.
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 given conflicting messages from 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.
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. See Joint Interagency Statement (November 24, 1998); Joint Interagency Letter (March 10, 1999) [hereinafter the "March Joint Letter"]; and Joint Interagency Letter (July 12, 1999) [hereinafter the "July Joint Letter"], by the SEC, FDIC, FRB, OCC, and OTS.
3. Loan Loss Allowances; Hearing Before the Subcomm. on Financial Institutions and Consumer Credit of the House Comm. on Banking and Financial Services, 106th Cong. (June 16, 1999) [hereinafter the "June Hearing"]
4. H.R. 10, 106th Cong. Section 251 (1999).
5. For example, when asked at the June Hearing whether it would be workable for the SEC to consult with the banking regulators prior to issuing loan loss reserve comments, the OCC expressed its concern that, ". . . because of examination timing and other logistical issues, . . . if practiced for all filings, [SEC consultation with the banking agencies] might detract from the SEC's ability to ensure that registrants receive timely reviews of their statements. A more efficient approach would be for the SEC to consult with bank regulators on filings where it has significant questions pertaining to a registrant's loan loss reserve." Testimony of Emory W. Rushton, Senior Deputy Comptroller for Bank Supervision Policy, OCC, at the June Hearing (Response to Question No. 4) (June 16, 1999). This approach was incorporated in the July Joint Letter.
6. As Harvey J. Goldschmid, General Counsel of the SEC, stated at the June Hearing in response to a question, "In my time at the SEC, any time there has been an important matter of policy, a bank restating, a major look at reserves, we have coordinated with the bank regulator involved. I think we would always do so."
7. At a minimum, however, the legislative language should be amended only to require SEC consultation in circumstances in which the SEC staff is determining whether to take a significant action in its review of the accounting for a financial institution's loan loss allowance.
8. 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.").
9. United States General Accounting Office ("GAO"), Report to Congress on "Depository Institutions: Divergent Loan Loss Methods Undermine Usefulness of Financial Reports," 3 (Oct. 1994).
10. Id. at 5.
11. Arthur R. Levitt, Chairman, SEC, Address to the New York University Center for Law and Business (September 28, 1998).
12. Michael H. Sutton, Chief Accountant, SEC, Address to the American Institute of Certified Public Accountants (November 7, 1997).
13. Joint Interagency Letter to Financial Institutions from the SEC, FDIC, FRB, OCC, and OTS (Mar. 10, 1999).
14. Statement of Policy on the Establishment and Improvement of Accounting Principles and Standards, Accounting Series Release (ASR) No.150 (Dec. 20, 1973).
15. 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) (Jan. 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.
16. Letter from Alan Greenspan, Chairman, FRB, to Arthur Levitt, Chairman, SEC (June 4, 1998).
17. Administrative Policy on Financial Statements, ASR No. 4 (Apr. 25, 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.
18. Supra, n. 16.
19. FASB Viewpoints, "Application of FASB Statements 5 and 114 to a Loan Portfolio" (Apr. 12, 1999).
20. Arthur Levitt, Chairman, SEC, Address at the Committee for Economic Development (May 19, 1999).
21. 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.
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