This article, which was written in September 2005 warns of impending inadequate loan loss reserves at banks as a result of certain provisions of Sarbanes Oxley.
So, would this be another in the long list of unintended side effects of legislation? Did the government, in effect, prevent banks from adequately reserving for future loan losses when times were good in order to prevent smoothing of earnings?
Interesting. Working in the finance/accounting departments of public companies since SOX started, I’ve heard it blamed for a lot of things already (;)) but this is an interesting point.
I’m not sure I want to hoist it up to the top of the pile of reasons, but I’d say, based on this article, it certainly contributed to the Perfect Storm of factors that has gotten us where we are right now.
I think that it was intended to avoid precisely what happened: by preventing them from putting money away on the “just in case” basis, it could be that it is supposed to stop them from floating lending schemes where they cannot reasonably predict the result. In other words, the assumption is that the banks will act rationally (oh, hey, we can’t be sure we won’t take a bath on that product, so we won’t offer it!).
Obviously, any such assumption was incorrect. 
The first bit here is interesting
Quote:
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.
Quote:
So SARBOX does not prevent banks from reserving money to head of a future credit crisis, it just prevents them from reserving that money in an unallocated fund, which could also be used to smooth results.
The provisons for dealing with potential default payments by debtors (my understanding of this come from dealing with customers with less than stellar credit ratings, and this was a few years back, I am probably talking out my arse) is to reserve the money against a specific account or invoice. It woulds seam from the quote above that reserves against a specific loan are allowed.
So if one of the contributing factors to the banking collapse is the lack of reserves, the problem is not that SARBOX did not allow them, it is the banks did not elect to make them in the correct way after the unallocated reserves were banned. Is there any reason that they could not have made allocations against specif loans and credit derivatives? (that is a real question, I dont know)
Why they would not have made the reserveas against the loan (if that is what happend) I dont know. My continuing wild arse geuss would be that by allocating reserves against specific loans, the banks would have been forced to recognise a greater risk present in the loans, thus would have had to hold a larger minimum capital requirement as per the BasleII Accords than they would have ringfenced with a more free and easy unallocated cover all fund. Having larger min capital requirment would have left the bank with less cash on hand, with less cash on hand they would not have been able make as many deals and make as much money.
File all the above under random musings.
…at the bank I managed. SOX is a royal pain in the butt, and I wish it would go away. But this is, at most, some twiddling around the margin.
But I don’t think it means that banks absolutely could not allocate such reserves if they’re unsure of where the loss is going to be. They could still have allocated the reserves and been wrong, they just would have had to explain how they were wrong in the annual report.
Sounds to me like another case of big business scapegoating reasonable legislation to explain away their own failures and to spur reform or repeal.
I agree with every word in your response, except for ‘reasonable’.
That was my point as well, although yours was much more succintly put. I am no fan of sarbox either, but it has some positive aspects even if is is a monster to deal with.
I can certainly understand your perspective, being on the frontline. But your pain-in-the-ass is the market’s boon.
The article has left out a few details. Banks are required to grade loans based upon the likelihood of default and the expected loss given a default. These are grades are usually updated on a periodic basis given the specifics of the borrower and collateral. For instance, if they analyze the financials at one date, the loan may be given a grade of “Pass”; if analyzed after deterioration in the company’s operations, it may receive a grade of “Low Pass”. The bank has a formula on how much reserves it can assign to a loan given the grades. You have to have some justification for the reserves that you assign. The article goes into the subject of unallocated reserves. What the banks and regulators were doing, presumably, was setting aside additional loan loss reserves on an unallocated, non-formulaic basis. They did this in order to be conservative. The accountants saw this as essentially a smoothing of earnings technique, which is not allowed.
Where is big business blaming anyone? This article was written during the good times as essentially a warning. There were no failures at the time it was written.
Inadequate loan loss reserves didn’t cause this crisis, bad investments did. Corporations will latch onto anything to shift the blame from their own mismanagement to mollify the shareholders.
Y2K, 9/11, Katrina,…all have been blamed for the poor performance of certain companies at some point.
Notice that I used the word exacerbate.