The Financial Accounting Standards Board’s new exposure draft on accounting for financial instruments, if adopted, could have adverse consequences for commercial banks, according to lobbyists and bank CFOs who are assessing its ramifications. Almost immediately after the proposal was published last Thursday, bankers began questioning its logic, particularly the requirement that even plain-vanilla loans held for collection be marked to market. Bankers say the ripple effects are numerous and include damping origination of long-term, variable-rate loans; spooking bank investors; and increasing procyclicality in the financial system.
“This is really a jaw-dropping proposal,” says Donna Fisher, senior vice president of tax and accounting at the American Bankers Association.
The proposed accounting changes, which would take effect in 2013 for banks with assets of more than $1 billion, would force companies to use market prices to value almost all financial instruments, including loans to corporations and consumer loans such as credit-card debt, and record any changes on the balance sheet. That’s a significant departure from current accounting practice for banks, which record held-to-maturity loans on the balance sheet at amortized, or historical, cost.
The changes to fair value will not flow to net income, FASB says. The changes would appear as a separate line on the balance sheet and in the statement of comprehensive income alongside amortized cost. Currently, components of other comprehensive income (OCI) are usually displayed in notes to financial statements. The proposal would also require banks to be more forward-looking in their estimation of credit losses.
“The objective…is to provide financial statement users with a more timely, transparent, and representative depiction of an entity’s exposure to risk from financial instruments,” FASB says.
But commercial bankers say the rules are antithetical to the business model of holding on to a loan and collecting the payments rather than selling it to a third party. “Our business is not buy and sell,” says Fisher. “If the cash flows are from the customer, there’s no reason to have those market fluctuations. You don’t want that craziness in your financial statements.”
How banks would perform such valuations is also under question. “We have a $5 billion investment portfolio and we can value it using Bloomberg,” says Michael Hagedorn, CFO of UMB Financial, a $12 billion (in assets) commercial bank. “But we would have to fair-value our loans using different discount rates and various assumptions, and I don’t see how that improves transparency.”
“[FASB] is trying to get to where any user can pull up a balance sheet and truly see on a mark-to-market basis the value of a company’s equity,” says Mike Rossi, finance chief at Dallas-based NexBank. “But what they will end up with is a situation where there is a ton of judgment involved.”
In an extreme situation, fair-value accounting might force a bank to take a market loss on the day it makes some loans, says Fisher. “Bankers know the borrower’s credit history better than the market does,” she comments. Even if a loan is fully performing, it will be worth more to the originator than to the market, she says. “They’re going to discount it.”
While bank CFOs don’t think overall lending volume would be directly reduced, the fair-value rules could steer banks away from making long-term, fixed-rate loans. Such credits would have more variability in a mark-to-market scenario. And, indirectly, any negative adjustments in OCI from falling loan values would reduce a bank’s total equity, which would potentially force it to cut back lending if the amount is large, Hagedorn says. In a tumbling financial market, hits to OCI could accelerate bank failures.
Having to mark loans to market would also increase the accounting burden on banks, says CFO Rossi. “As long as a loan is performing, there is no accounting that needs to be done,” he says. “The [new FASB rule] will require us to hire another couple of people on an accounting staff of three. That would ultimately manifest itself in higher rates or fees.”
According to a member survey by the CFA Institute last November, 52% of investment professionals said it was appropriate to record loans at fair value based on the notion of an exit price. The FASB proposal, however, diverges from the International Accounting Standards Board’s recommended loan-loss rules, which would have non-U.S. companies carry loans held for collection at amortized cost. The difference could add another roadblock to global accounting convergence, say experts.
One aspect of the exposure draft is being greeted with a modicum of acceptance by banks. In trying to get banks to provide more-timely information on credit impairments, FASB aims to change the model banks use for accounting for credit losses. Fisher says this part of the exposure draft is a good thing. The traditional “incurred loss” model — in which banks have to accrue losses if they are probable and reasonably estimable as of the date of the financial statement — would be replaced by an “expected loss” model, in which banks would look forward and extrapolate their level of potential bad debts. The change might prevent banks from relying too much on historical data from previous economic cycles.
To make the exposure draft easier to swallow, the board will give nonpublic banks with less than $1 billion in total consolidated assets four years from the effective date to adopt the change in fair-value accounting.
FASB is accepting public comments on its proposal until September 30. It plans to hold public meetings on the exposure draft in October.
