Bankers Fear FASB Plan Too Inflexible on Asset Sales

WASHINGTON — A regulatory plan that changes how banks must account for holdings on their books is stirring anxiety in the financial services industry that it may force banks to make a premature decision about what they intend to do with an asset.

The Financial Accounting Standards Board's plan, part of a broader project to align U.S. and global accounting standards, abandons the unpopular idea of comprehensive fair value reporting, much to bankers' delight.

But it would also provide little wiggle room to change the stated plans for an asset — either to hold it long-term or sell it — without sparking fair value results. The plan may also still lead investors to focus on a fair value determination for certain long-term assets.

"The new standard would mean banks classify them at the time you originate them, and can't reclassify them," said Michael Gullette, vice president of accounting and financial management at the American Bankers Association. "But you may not know which ones you want to hold and which ones you want to sell at that time. It would make it harder for them from a procedural perspective that they have to identify those loans upfront."

In the latest draft plan released on Feb. 14, the accounting standards board proposed a simpler classification system than today's standard, which would reduce the current five categories used to classify assets and liabilities to three. How an institution classifies a holding depends on the bank's established business model for managing the return and cost of balance sheet items.

The first category, "amortized cost", includes assets that a financial institution plans to hold until maturity and on which it collects principal and interest payments. Under the plan, that category would avoid fair value treatment. Banks have long opposed fair value treatment for longer-term holdings, arguing it serves no purpose to tell investors what the value might be under current conditions when the bank does not plan to sell an asset until later.

Fair value treatment would still occur in the other two buckets under FASB's plan.

Loans or securities that could be held long term but may be sold at some point would be classified as "fair value through other comprehensive income." Assets very likely to be sold, meanwhile, would go into the "fair value through net income" category and follow the strongest mark-to-market requirements. (Liabilities would basically get the equivalent of an amortized cost classification.)

"If it's only principal and interest, then it's eligible for cost accounting" instead of fair value accounting, FASB Chairman Leslie Seidman said in an interview.

"It was on the basis of … feedback that we made the change to essentially acknowledge a widespread view that if you have plain vanilla debt instruments and you're planning to hold them for collection of cash flow, then the amortized cost — or basically those cash flows — is the most relevant piece of information for the balance sheet relating to those items."

Executives and industry representatives applauded FASB for stepping away from across-the-board fair value requirements considered in a 2010 draft, but still expressed concerns about proposed restrictions on reclassifying assets if a bank decides to sell loans or securities it had previously planned to hold.

If the bank were to sell even a small portion of assets designated to be held for their entire maturity periods, it would effectively be considered "tainted" under accounting rules, subjecting the entire portfolio to fair value consequences.

James Kendrick, a vice president at the Independent Community Bankers of America, said FASB's backtrack away from across-the-board fair value accounting is a "positive." But he said community banks may avoid the "amortized cost" bucket altogether if they cannot reclassify them at a future date.

"Community banks are going to like the amortized-cost bucket because it's very straightforward, does not rely on a mark to market concept … and reflects the long term lending nature of a community bank," he said.

But they may opt for a different classification, he added, to leave open the possibility of selling the loans on the secondary market.

"They could … reach a conclusion that putting it in anything other than that second bucket could cause problems down the road," Kendrick said.

But Seidman said companies can discern more definitive classifications through looking historically at their business models.

"If an entity is managing its interest rate risk by either holding assets to maturity or selling the assets — but it's really a day by day decision which to do — that group of assets would be classified as fair value through other comprehensive income because the entity is going to decide on a periodic basis whether to hold or whether to sell," she said. "If I compare that with a loan portfolio, typically an entity is going to hold those loans for collection of cash flow and have their primary focus be managing the collection of cash flow.

"The feedback we received was there are observable business practices that entities are engaging in, and we tried to line up the accounting classification to mirror those business practices."

The proposal, which applies to all reporting institutions that have financial instruments on their balance sheets, says reclassifications would occur "very infrequently," and only when the institution undergoes a change in business model. "The entity would account for the reclassification prospectively and would recognize the reclassification on the last day of the reporting period in which the business model changes," the board said. (The public has until May 15 to comment.)

It also lists the limited circumstances, other than a company's efforts to mitigate the effects of a credit event, when an institution can sell an asset from the amortized cost bucket without triggering fair value consequences. Those circumstances would include certain statutory or regulatory changes, mergers of two companies with different business models, or significant increases in capital requirements or risk weights for debt instruments.

"Sales that result from reasons other than managing credit exposure should be very infrequent," the proposal said.

But some executives said that retains some of the concerns banks had about fair value accounting in the first place.

Raj Mehra, the chief financial officer of Middleburg Bank in Virginia, said FASB needs to provide more detail on whether "tainting" still applies — in other words that sales of holdings out of the first bucket can still subject an entire portfolio to fair value.

"If tainting stays, I don't think we've achieved much. If tainting goes away, then that is a big plus for the industry. Right now it's unclear and FASB needs to provide some clarification about the transfer of assets between buckets," Mehra said.

Mehra and others also objected to a requirement in the proposal that publicly traded companies still provide parenthetical fair value information about certain "amortized cost" assets to assist investors. (His bank is publicly traded.)

"FASB has come a long way, but I don't even know why the fair value of loans belongs anywhere in the proposal," Mehra said. "Why ask banks to disclose the information? Once you disclose it, investors are going to want to know where that information comes from and will start using it to compare different banks. The comparisons themselves could be misleading. They may overplay the significance of the number."

Peter Stickler, the chief financial officer of Inland Bancorp in Oak Brook, Ill., said some institutions would prefer flexibility to move certain securities between categories based on developments in the market.

"When rates start to go up, bond portfolios are going to have losses. To try to mitigate that, more banks would try to transfer securities into the held-to-maturity category," he said. "But the scare has always been that if you sold something out of the held-to-maturity portfolio, then you would taint the whole portfolio and everything would be available for sale."

Gullette noted the board could consider revisions to give lenders some lead time following an origination to decide how to classify certain loans. He used the example of a bank agreeing to sell 60% of a portfolio to either Fannie Mae or Freddie Mac, and keep the rest, but does not know immediately which loans will go and which will stay.

"There is a timeframe of those first couple of months after you've originated them where the bank might not have decided," he said. "Quite honestly, I think in that respect as long as there is disclosure … there will be an understanding that if you put something in amortized cost and you've sold it within the first couple of months, I don't think that's going to be a big problem. People know that that's part of your business. It's those sales that happen after you've held the loan for a year … that will start to prompt questions."

Seidman said the board will continue to seek feedback from all stakeholders as it continues to develop the standard.

"We're very much planning to engage with banks as preparers of financial statements, but also investors and users of financial statements, to gather their input on this proposal," she said.