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The methodology to recognize loan losses set forth by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) is referred to as the incurred loss model and defined as the identification of inherent losses in a loan or portfolio of loans. Inherent credit losses, under current accounting standards in countries following FASB and IASB, are event driven and should only be recognized upon an event's occurrence.1 This has tended to mean that reserves for loan losses on a bank's balance sheet need to grow significantly during an economic downturn, a time associated with increased credit impairment and default events. Critics of the incurred loss model have pointed to it as one of the causes of the severity of strain many financial institutions experienced at the onset of the financial crisis of 2007-2009. As rapid provisioning to increase loan loss reserves made headlines, discussions of international regulatory banking reform included the method of dynamic provisioning as a potential alternative to the incurred loss approach (see, for example, Cohen 2009). Dynamic provisioning is a statistical method for loan loss provisioning that relies on historical data for various asset classes to determine the level of provisioning that should occur on a quarterly basis in addition to any provisions that are event driven.2 The primary goal of dynamic provisioning is the incremental building of reserves during good economic times to be used to absorb losses experienced during economic downturns.
We begin this paper with a discussion of the current approach to loan loss reserves (LLR) in the United States. We argue that, to a social planner who cares both about avoiding bank failures and the efficiency of bank lending, the current accounting and regulatory approach for LLR may be suboptimal on both fronts. First, by taking provisions after the economic downturn has set in, a bank faces higher insolvency risk. When a banker or regulator determines that a bank has inadequate LLR, the bank will have to build the reserves in an unfavorable economic environment. Also, inadequate reserves imply that regulatory capital ratios have been overstated, placing the bank at a higher risk for resolution by the Federal Deposit Insurance Corporation (FDIC). Second, as most banks tend to increase LLR...