How should banks account for loan losses

Existing GAAP treatment of banks’ loan losses follows the treatment of other contingencies. Bank supervisors expect reserves to at least cover expected losses. The FASB’s goal is to move to fair value accounting. We find that the book value of loans before deducting the loss allowance generally understates their value, suggesting that the bank supervisors are excessively conservative. We further find that fair value is not verifiable for many loans because of adverse selection risk. We recommend that the allowance be limited to: (1) losses which could have been charged off but were not, and (2) large losses when the economic value is less than the book value of a loan portfolio.