Banks were woefully unprepared for collapse of the housing market. Their lack of an adequate cushion to absorb loan losses contributed to the resulting credit lockdown.

The industry deserves blame for failing to build adequate loan loss reserves during the past decade's boom. But regulators also deserve a fair measure of responsibility. Accounting and securities rules conspired to discourage adequate reserving even though many predicted bad times were on the way.

Comptroller of the Currency John Dugan, the regulator of U.S. national banks, is working to rewrite the rules so banks are better prepared for the next downturn.

"We would be considerably better off today if there had not been so many impediments to building larger reserves," he told the Institute of International Bankers in March. "Had banks built strong reserves during the boom years, they would not need to reserve as much now; they wouldn't need as much additional capital now; and they would be in a stronger position to support economic growth." Dugan co-chairs a working group of the Financial Stability Forum, formed in 1999 to foster cooperation among national banking regulators. Dugan's partner heading the group is Securities and Exchange Commission member Kathleen Casey.

On April 2, the group submitted its proposed changes to the Basel Committee on Banking Supervision, the group of G-10 central bankers that has established so-called best practices for banking safety and soundness. The committee's guidelines are not binding on member countries, but banking regulators around the globe generally adopt its recommendations.

The current Basel II capital regime, adopted in 2004, allows financial institutions to determine their own capital levels as determined by internal risk models. Regulators are beginning to recognize that Basel II failed to protect the international financial system from the increasing use of leverage and forays into ever-more-complex investment vehicles.

Rethinking loan loss reserve practices is one component of the broader reassessment of Basel II. Dugan acknowledges that bankers were "lulled into an unwarranted sense of complacency" by the prolonged period of economic growth that stretched from the mid-1990s until 2007. But a "more fundamental constraint" of misguided regulation would have hindered any bankers who might have been inclined to set more aside. Since 1998, SEC accounting rules have limited how much banks can set aside for loan losses. That year the SEC alleged that SunTrust Banks Inc. had taken "excessive reserves" and forced the bank to restate its earnings, requiring a $100 million boost to net income. The SEC's action followed an investigation into whether banks were putting too much into reserves to "manage" their earnings. Prudence might dictate that boosting reserves is wise, but the SEC argued that banks were wrongly flattening their earnings during strong quarters to dampen the contrast with weaker periods.

Though bank regulators and Congress complained that banks would be reluctant to prepare for down times, the SEC held its ground. Ever since, auditors have leaned on banks to keep loan loss reserves in check during long periods of economic growth. The SEC accounting rules permit a bank to reserve against losses that have been "incurred," meaning a loan loss is probable and can be reasonably estimated. To document an incurred loss, banks must base their calculations on historical loss rates for similar types of loans. During good times loss rates decline, making it hard to justify more reserves. Basel rules compound that difficulty. Reserves count toward Tier 2 capital but only up to 1.25% of risk-weighted assets. (Tier 2 capital is considered secondary capital and doesn't count as Tier 1, or core capital, because reserves are set aside for losses on specific loans and therefore unavailable to cover unexpected losses as Tier 1 capital is.)

Dugan wants to raise the Tier 2 cap. He also favors replacing the historic incurred-loss model with "life of the loan" or some other concept with a longer time horizon. Even the SEC appears ready to liberalize banks' reserving rules.

"We want to strike a balance between building strong reserves early in the economic cycle and at the same time meeting investors' objective of trying to understand what's in their portfolio," says Kevin Bailey, OCC deputy comptroller for capital and regulatory policy. And regulators should not back down if the industry balks at boosting reserves when the good times return. "Our memory is going to be pretty long."

Bill McConnell is The Deal's Washington bureau chief.