However, this increase, remarkable as it is, has not kept up with the increased need for such funds. The relationship of such capital to both so-called risk assets and to loans, far from increasing, has actually declined during this period, as may be seen from the following chart:

The cause for the decline of bank capital in relation to risk has been due to two causes:

First, the unprecedented growth in loans over the past 15-year period (from $18,394 million in 1940 to $82,081 million in 1955), and

Second, the difficulty in building up capital funds.

The difficulty in building adequate capital lies in the insufficiency of bank earnings, after taxes, to pay even a modest dividend and yet provide sufficient additions to capital funds.

Bank earnings are moderate. For the past 15 years a period of unparalleled profit for American business, the after-tax earnings of all insured banks have averaged a return on net worth (capital accounts) of only 8.2 percent.10 Last

7 "Risk assets" is used by the Comptroller of the Currency to refer to total assets minus cash and U. S. Government bonds.

8 Based on capital, risk assets, and loan figures in the FDIC annual reports for the period from 1940 to 1955.

9 Ibid.

10 Based on bank earnings and capital accounts at the end of the year as shown in successive annual reports of the FDIC, 1940-55.

year, an outstanding year for our economy generally, earnings of all insured banks amounted to only 7.9 percent." Earnings for the first 6 months of 1956 are at a comparable level. Clearly bank earnings are lower than the earnings of most other industries.13

12

(ii) Capital growth cannot be the solution

Of its 15-year average earnings of 8.0 percent, the banks paid less than half of this (42 percent) in dividends-an average return to the stockholder of less than 3.4 percent. The balance of the banks' earnings were added to capital funds. Yet such earnings were not adequate to increase capital funds at a rate comparable with the increased demand for credit."

Thus, we face the disturbing conclusion that, despite the fact that our country has enjoyed a period of unprecedented prosperity, our banking system has not only been unable to use this period to build up its capital funds in relation to the risk of loss, but, on the contrary, its ratio of capital funds to risk assets has actually declined. It is lower today than in 1940.5 It is even lower today than it was in 1929.16

It is apparent that capital funds alone cannot serve as the cushion to absorb future losses. Perhaps less apparent, but no less certain, is the fact that capital funds should not be called upon to absorb any losses except in extremis. If during the depths of a depression a bank must show in each successively published statement further impairment in its capital accounts, it cannot but further disrupt depositor confidence. Indeed, the losses themselves, plus the erosion of deposits as a result of depositor fear, may impair the ability and courage of the bank management to provide the credit so necessary to prevent further retrenchment in business activity and resultant unemployment. Loan losses should be absorbed by something other than capital accounts.

It might be thought that loan losses could be absorbed by current income, and, indeed, they can be in a normal year. However, the experience of the last depression demonstrated that losses so far exceeded income that it is most unwise to postpone providing against losses until after they are sustained. It is for this reason that public policy require some provision for adequate reserves which will be sufficiently simple and useful to induce all banks to so prepare themselves for the future.

17

Loan losses should be absorbed by reserves set up precisely for that purpose and so designated. This was recognized by a few bankers as early as the 1920's,1 but very few banks had such reserve in the 1930's. It was this fact that caused the failure of so many banks and further deepened the trough of the depression. Following the depression bankers and supervisors alike realized the importance of some adequate provision for reserves for such losses. It is not important to single out any individual or group to credit with the "discovery," but it is worthwhile to pay tribute to the many men, both on the tax committee of the American Bankers Association, in the Treasury Department, and in State associations, who have worked toward the end of adequate reserves for bad debts. They have accomplished much. Yet only about one-half of the banks have any reserves for bad debts, and the total of all reserves for bad debts of all insured commercial banks amount to only 1.67 percent of loans.1

18

11 Taking classes of banks, earnings on average capital for national banks were 8.1 perment; for nonmember banks. 8 percent; for all member banks. 7.9 percent for member State banks, 7.5 percent (FDIC, annual report, 1955, pp. 136-141); Federal Reserve Bulletin, May 1956, p. 436. These figures reflect, only to a very slight extent, the tremendous decline in the market price of Government bonds which composed so large a portion of bank assets.

12 The Board of Governors of the Federal Reserve System has reported in August that the earnings of all member banks for the first 6 months of 1956 were 8.4 percent of capital accounts as compared to 7.9 percent for the same period in 1955. See American Banker for August 13. 1956.

13 Of industries ranked according to return on shareholder equity, banking was in the bottom quarter. Quarterly Financial Report for Manufacturing Corporation published by Federal Trade Commission and Security Exchange Commission for fourth quarter, 1955. pp. 4-17.

14 The poor earnings and dividend records also make it difficult for a bank to increase capital through the sale of additional stock except on terms most disadvantageous to existing stockholders.

15 FDIC, annual report, 1940, pp. 144, 147.

16 Banking and Monetary Statistics, Board of Governors of the Federal Reserve System, 1943. pp. 72-73. Data for all member banks.

17 The reserve method was first officially recognized by the enactment of sec. 234 (a) (5) of the Revenue Act of 1921.

18 According to FDIC, annual report, 1955, p. 42, total reserves for bad debts amounted to 1.67 percent of total loans.

2. THE PRESENT LAW AND REGULATIONS

A. The absence of any statutory provision

Our comments which follow concerning the level of present reserves are not intended to reflect on the ability or industry of those who have so long labored to achieve reasonable reserves through administrative action-but, on the contrary, demonstrate the necessity for legislative provision.

There is nowhere in any Federal statute any specific provision for reserves for bad debts of commercial banks. There are such provisions in respect of mutual savings banks, there are such provisions in respect of savings and loan associations--but there are not any such provisions in respect of commercial

banks.

The only statutory authority for any deductible additions to bad debt reserves for commercial banks is the provision in section 166 (c) of the Tax Code of 1954 which was enacted primarily to accommodate merchants.

Disregarding the needs peculiar to banking, it provides for all alike; "Sec. 166. * * *

"(c) Reserve for bad debts.-In lieu of any deduction under subsection (a), there shall be allowed (in the discretion of the Secretary or his delegate) a deduction for a reasonable addition to a reserve for bad debts." 19

The Congress in effect passed to the Secretary of the Treasury the responsibility for determining what additions to reserves for bad debts were "reasonable." The Secretary and his delegates have recognized, at least since 1947,20 that past

10 This is substantially sec. 23 (k) (1) of the 1939 code.

20 On December 8, 1947, the Commissioner of Internal Revenue issued mimeograph 6209, which provided that a bank could use a consecutive 20-year period ending with the current year to determine both its maximum annual addition to a reserve for bad debts and the maximum reserve which could be established. This reads: SECTION 29.23 (k)-5: Reserve for bad debt

1947-25-12717 Mim. 6200

Reserve method of accounting for bad debts in the case of banks

TREASURY DEPARTMENT, OFFICE OF COMMISSIONER OF INTERNAL REVENUE, Washington 25, D. C., December 8, 1947. Collectors of Internal Revenue, Internal Revenue Agents in Charge, Technical Staff, and Others Concerned:

1. The Bureau has given careful and extended consideration to the situation of banks in general with respect to the use of reserves for bad debts, the proper measure of such reserves, and amounts to be allowed as deductions.

The Tax

2. In determining a reasonable annual addition to a reserve for bad debts by a bank it is believed to be fair and sufficiently accurate to resort to the average annual bad-debt loss of the bank over a period of 20 years, to include the taxable year, as constituting a representative period in the bank's history and to accept the equivalent percentage of presently outstanding loans as indicative of the probable annual accruing loss. Court has held that the "use of the reserve for bad debts is not inherently inconsistent with a cash basis where, as here, the reserve is against loss of capital only *** and contains no element of income which has never been reported. * **Such a reserve for loss of capital does not differ materially from a reserve for depreciation which is set up on a percentage basis rather than on the basis of actual depreciation suffered." (See Estate of Maurice S. Saltstein v. Commissioner, 46 B. T. A., 774, 777, acquiescence, C. B. 19421, 14.) However, such reserve cannot be permitted to accumulate indefinitely simply because of the possibility that at some future date large losses may be concentrated within a relatively short period of time and operate to absorb the greatest probable reserve. permit this would sanction the deduction of a mere contingency reserve for losses, which is not an allowable deduction for income or excess profits tax purposes. This latter rule makes imperative the imposition of some reasonable ceiling on the accumulation of the reserve other than such indefinite limitation as might eventually prevail under a moving average method.

Το

3. The Bureau has accordingly approved the use by banks of a moving average experience factor for the determination of the ratio of losses to outstanding loans for taxable years beginning after December 31, 1946. Such a moving average is to be determined on a basis of 20 years, including the taxable year, as representing a sufficiently long period of a bank's experience to constitute a reasonable cycle of good and bad years. The percentage so obtained, applied to loans outstanding at the close of the taxable year, determines the amount of permissible reserve in the case of a bank changing to the reserve method in such year (see first year in following computation) and the minimum reserve which the taxpayer will be entitled to maintain in future years (see second year in following computation). A bank, following a change to the reserve method of accounting for bad debts, may continue to take deductions from taxable income equal to the current moving average percentage of actual bad debts times the outstanding loans at the close of the year, or an amount sufficient to bring the reserve at the close of the year to the minimum mentioned above, whichever is greater. Such continued deductions will be allowed only in such amounts as will bring the accumulated total at the close of any taxable year to a total not

losses embracing a period of depression should serve as the basis for determining the adequacy or reasonableness of such reserves. But, as might be expected, the Government official primarily responsible for balancing the budget has been at least, or perhaps more, concerned with that responsibility than he has with the less personal responsibility for protecting bank depositors, or providing a source of revitalizing credit in the next depression.

B. The regulation

The Secretary's regulations presently in force permit a commercial bank to make annual deductions from taxable income as additions to reserves for bad debts but subject this privilege to two limitations which, somewhat simplified, may be expressed as follows:

(a) The aggregate amount of such reserves which can be built up over a period of years is limited to 3 times the individual bank's average loss experience factor in its worst 20 years subsequent to 1927, times the amount of its loans outstanding at the end of the taxable year.

exceeding three times the moving average loss rate applied to outstanding loans (see fifth year in following computation).

Example of the application of the foregoing with amount of outstanding loans remaining unchanged at

1.

2

3.

4.

5

Year

$1,000,000.

4. In computing the moving average percentage of actual bad debt losses to loans, the average should be computed on loans comparable in their nature and risk involved to those outstanding at the close of the current taxable year involved. Government insured loans should be eliminated from prior year accounts in computing percentages of past losses, also from the current year loans in computing allowable deductions for additions to the reserve. Losses not in the nature of bad debts resulting from the ordinary conduct of the present business should also be eliminated in computing percentages of prior losses.

5. A newly organized bank or a bank without sufficient years' experience for computing an average as provided for above will be permitted to set up a reserve commensurate with the average experience of other similar banks with respect to the same type of loans, preferably in the same locality, subject to adjustment after a period of years when the bank's own experience is established.

6. Bad debt losses sustained are to be charged to the reserve, and recoveries made of specific debts which have been previously charged against the reserve by a bank on the reserve method of treating bad debts should be credited to the reserve.

7. Where a bank making its return on the basis of the calendar year 1947 wishes to avail itself of the provisions of this mimeograph and to change from the specific charge-off to the reserve method of accounting for bad debts, the time for making application for such change under section 29.23 (k)-1, Regulations 111 has been extended to March 15, 1948 (T. D. 5594, approved December 8, 1947 [page 25, this Bulletin]). If such bank files its return on or before March 15, 1948, on the reserve method, and the return is accompanied by a written statement setting forth the election to use such method and explaining in detail the computations of the bad debt deduction shown in the return, such return will be accepted as a timely application.

8. The term "banks" as used herein means banks or trust companies incorporated and doing business under the laws of the United States (including laws relating to the District of Columbia), of any State, or of any Territory, a substantial part of the business of which consists of receiving deposits and making loans and discounts.

9. Correspondence in regard to this mimeograph should refer to the number and to the symbols IT: ELM.

Approved December 8, 1947.

A. L. M. WIGGINS,

GEO. J. SCHOENEMAN,

Commissioner.

Acting Secretary of the Treasury.

(b) The amount which can be deducted from taxable income in any 1 year cannot exceed one-third of the aggregate reserve in the first year, one half of the remainder in the second year or all of the remainder in the third year.21

21 Mimeograph 2609 (set out in footnote 20) was supplemented by the provisions of Revenue Ruling 54-148 originally, promulgated as I. R. Mimeograph 54-55 on April 8, 1954. These read:

REGULATIONS 118, SECTION 39.23 (k)-5: Reserve

for bad debts.

Rev. Rul. 54-148*

A bank, in computing a reasonable addition to its reserve for bad debts, may use an average experience factor based on any 20 consecutive years of experience after 1927, in lieu of a moving average experience factor determined on a basis of 20 years including the taxable year.

Com.-Mimeograph Coll. No. 6209, C. B. 1947–2, 26, supplemented.

SECTION 1. PURPOSE.

The purpose of this Revenue Ruling is to supplement Com.-Mimeograph Coll. No. 6209 dated December 8, 1947 (C. B. 1947-2, 26), which authorizes, in the case of banks, a special method for computing a reasonable addition to the reserve for bad debts under section 23 (k) (1) of the Internal Revenue Code and the regulations promulgated thereunder. SEC. 2. BACKGROUND.

The Service has carefully reexamined the provisions of Mimeograph 6209, supra, in the light of experience developed thereunder and, as a result of such reexamination, has approved an alternative method for the use of banks in computing the annual addition to the reserve for bad debts and the maximum amount permitted to be accumulated in such reserve, as set forth in section 4 hereunder.

SEC. 3. DEFINITION OF TERMS.

The term "banks" as used herein means banks or trust companies incorporated and doing business under the laws of the United States (including laws relating to the District of Columbia), of any State, or of any Territory, a substantial part of the business of which consists of receiving deposits and making loans and discounts. Such term as used in Mimeograph 6209 and herein does not include mutual savings banks not having capital stock represented by shares, domestic building and loan associations, or cooperative banks without capital stock organized and operated for mutual purposes and without profit. SEC. 4. ALTERNATIVE METHOD.

.01 In lieu of the moving average experience factor provided in paragraph 3 of Mimeograph 6209, which is determined on a basis of 20 years including the taxable year, a bank may use an average experience factor based on any 20 consecutive years of its own experience after the year 1927. Such average experience factor, representing the percentage of bad debt losses to loans for the period selected, applied to loans outstanding at the close of the taxable year, determines the maximum permissible addition to the reserve for the

year.

.02 The amounts permitted to be added in each taxable year to the bad debt reserve under (.01) above may not exceed an amount which will bring the accumulated total in the bad debt reserve at the close of the taxable year to a ceiling equal to three times the average experience factor applied to outstanding loans: Provided,

1. That for the first taxable year beginning after December 31, 1953, the amount of the addition therein to the reserve computed under (.01) above may not exceed one-third of the difference between the ceiling so computed and the accumulated total in the reserve at the close of the year before the addition; and

2. That for the second taxable year beginning after December 31, 1953, the amount of the addition therein to the reserve computed under (.01) above may not exceed one-half of the difference between the ceiling so computed and the accumulated total in the reserve at the close of the year before the addition.

.03 Consistent with the provisions of Mimeograph 6209 which permit newly organized banks and banks without sufficient years' experience of their own to set up a reserve commensurate with the average experience of other similar banks with respect to the same type of loans, preferably in the same locality, banks which select a 20-year period under (01) above which extends back into years for which they have no experience of their own will be permitted to fill in such years with similar comparable data.

.04 The provisions of paragraph 6 of Mimeograph 6209 relating to the treatment of specific bad debt losses and recoveries, and all other rules utilized in the application of Mimeograph 6209 shall, to the extent not inconsistent, be applicable to the alternative method.

SEC. 5. EFFECT ON OTHER DOCUMENTS.

This Revenue Ruling merely supplements Mimeograph 6209 by providing an additional or alternative method for computing the annual addition to a reserve for bad debts and the maximum amount permitted to be accumulated in such reserve. Banks which are now using the moving average method provided in Mimeograph 6209 may continue to use that method if they so desire, and such method is still available to any other banks using or changing to the reserve method of accounting for bad debts.

SEC. 6. BANKS ON SPECIFIC CHARGE-OFF METHOD.

Where a bank on the specific charge-off method of accounting for bad debts desires to avail itself of the provisions of this Revenue Ruling and change to the reserve method, application to make such change must be made in the manner prescribed by section 39.23 (k)-1, Regulations 118.

SEC. 7. EFFECTIVE DATE.

The provisions of this Revenue Ruling are applicable only for taxable years beginning after December 31, 1953.

Approved by M. B. Folsom, Acting Secretary of the Treasury, April 8, 1954. *Originally issued as I. R. Mimeograph No. 54-55, dated April 8, 1954.