Banks Fear Latest Move By FASB On Securities

The Financial Accounting Standards Board dropped a bombshell last week with its latest proposal for mark-to-market accounting of banks' unrealized gains and losses on investment securities.

Under the rule, changes in the market value of a bank's investment portfolio would show up in that bank's net income every quarter - even if the bank bought the securities with the expectation of holding them for years.

The standards board views the step as a logical extension of efforts to ensure that financial statements reflect the true value of securities.

More Volatility Feared

But critics charge that the latest mark-to-market proposal would distort earnings reports without shedding any useful light on a bank's financial condition.

"It's misguided accounting policy," said Richard Lodge, a senior vice president at Banc One Corp. "It will exacerbate volatility in bank earnings. There's no reason to put unrealized gains and losses in the income statement, because that suggests securities are about to be sold when they're not."

The standards board has been discussing how to require banks to use market value accounting for certain marketable securities for more than a year.

A draft proposal for a market value accounting rule will be circulated for public comment early next year.

The board tentatively decided last month to propose allowing banks to report unrealized gains and losses on such securities in their retained earnings account, where they would have no effect on income.

But all that changed abruptly at a meeting last Wednesday. On the agenda: whether to reflect unrealized changes in market value for four types of securities in income while reflecting unrealized changes in market value for all other securities in retained earnings.

A Vote to Avoid Complexity

Confronted with this list of exceptions, the board altered course. Eager to avoid setting up a complex rule riddled with exceptions, it voted to propose reflecting all unrealized changes in market value in the income statement.

"When the board members saw the complexity that would have to be addressed [if unrealized gains and losses were reported only in retained earnings], they decided it was just too much," said Robert Wilkins, the board's project manager in charge of the market value accounting project.

Ironically, well-capitalized banks will probably be the ones most upset by the board's change of direction. They were not terribly worried about showing unrealized gains and losses in their retained earnings because they had plenty of equity.

That meant their capital ratios were likely to remain high even if they had unrealized losses in a given period.

If the board's latest proposal is formally adopted, though, even strong banks - long accustomed to robust, stable earnings - will find themselves having to report extremely variable income, in addition to the changes in retained earnings. (Net income or losses get folded into a bank's retained earnings. Income increases retained earnings - part of shareholders' equity - while losses have the opposite effect.)

Effect on Investment Strategy

The board's current view could affect what types of securities banks buy. In an attempt to reduce the price volatility in their portfolios, banks might start buying more short-term securities, according to William Tennille, a managing director at Manufacturers Hanover Corp.

Banks might also try and hedge their investments more, limiting the downside risk but also curtailing the potential for big gains on their holdings, he said.

"Unrealized gains and losses were going to get to capital anyway" if they were reflected in retained earnings, he said. But "this will distort income. To the extent the market shifts around, you'll have bulges and dips in earnings."

To be sure, in light of other changes afoot in the world of banking regulation, the impact of this proposal alone may be limited.

For example, regulators are already considering limits on the types of mortgage-backed securities banks should be allowed to buy.

Bad Timing for the Industry

But even if its impact is limited, the board's change in direction comes at an inopportune time for the industry.

Banks are struggling under the weight of souring loans, and they are already hard pressed to give their earnings any semblance of stability.

"This represents a significant change in a negative direction," said Donna Fisher, manager of accounting policy for the American Bankers Association.

What's worse, the board's proposal has been launched when interest rates are lower than they have been in years. When interest rates are lower than they have been in years. When interest rates are low, prices on debt securities tend to be high - and when rates start to rise, those prices will fall.

That means banks could soon have unrealized losses going forward on many of their investments, even though they have reaped unrealized gains as interest rates have fallen.

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