NCUA's Treatment of ALLL in Risk-Based Capital Proposal Differs from Bank Standards

In its risk-based capital proposal, the National Credit Union Administration is proposing to remove the 1.25 percent of risk asset limit on the amount of the allowance for loam and lease losses (ALLL) that can be included in the risk-based capital ratio numerator.

However, this position differs from the stance taken by the Basel Committee on Banking Supervision (the Committee).

In a 1991 amendment to the Basel Capital Accord, the Committee noted:

"General provisions or general loan-loss reserves are created against the possibility of losses not yet identified. Where they do not reflect a known deterioration in the valuation of particular assets, these reserves qualify for inclusion in tier 2 capital. Where, however, provisions or reserves have been created against identified losses or in respect of an identified deterioration in the value of any asset or group of subsets of assets, they are not freely available to meet unidentified losses which may subsequently arise elsewhere in the portfolio and do not possess an essential characteristic of capital. Such provisions or reserves should therefore not be included in the capital base."

In other words, if the loan loss reserves are established for identifiable losses, then they do not possess the essential characteristic of capital -- the ability to absorb unidentified losses -- and should not be included in the capital base.

The Committee further noted in the original 1989 Capital Accord that "it is not always possible to distinguish clearly between general provisions (or general loan-loss reserves) which are genuinely freely available and those provisions which in reality are earmarked against assets already identified as impaired."

This inability to distinguish between identified and unidentified losses resulted in capping the amount of ALLL being counted as Tier 2 capital at 1.25 percent of risk assets.

The proposal would overstate the amount of Tier 2 capital available to absorb losses and will make the comparison of bank versus credit union risk-based capital ratios more difficult.

Read the 1989 Capital Accord.

Read the 1991 amendment.