Debate RagesOn Derivatives Plan by FASB

As a risk manager for BankAmerica Corp. in San Francisco, Steve Dixon is paid to track the twists and turns of the economy. But these days his biggest headaches are being caused by policymakers clear across the country.

The Financial Accounting Standards Board, the quasi-governmental body in Norwalk, Conn., that sets the rules for earnings statements and balance sheets, is trying to require that derivatives be reported every quarter at their market value.

Mr. Dixon is among the bankers who complain that the FASB plan would mislead investors because the market values of derivatives can change drastically over a few weeks or months. They say the instruments pose little danger when used over the long term to hedge against interest rate changes, inflation, or other economic risks.

To avoid earnings gyrations from quarter to quarter, banks might quit using derivatives, which ironically could expose them to greater risk.

"FASB's plan creates perverse incentives to reduce hedging activity," Mr. Dixon said. "It would force banks to choose between managing risk in a safe and sound manner while enduring increased volatility in their earnings statements or leaving risks unhedged."

FASB members argue that inconsistent reporting rules leave investors in the dark about the potential for losses posed by the billions of dollars in derivatives held by U.S. corporations. Several times in recent years, investors have been surprised by large losses related to derivatives.

"We've made it clear this information is important to investors," board member Neel Foster said at FASB's Dec. 17 meeting. "I think we ought to go ahead."

The controversy has twice led the accounting body to delay adoption of the rule. FASB voted last month to postpone its effective date to June 15, 1999.

The largest banking companies are in the vanguard of the opposition, but the entire banking industry has a stake in the outcome. The derivatives rule is the first step in FASB's effort to require that all financial instruments be carried on company books at fair market value.

Bankers warn that even conservative investments such as Treasury securities and local general obligation bonds could cause earnings volatility if the effort succeeds.

"The bigger issue is the whole direction that FASB is moving," said John J. Dolan, chief financial officer at First Commonwealth Financial Corp., a $1 billion-asset holding company in Indiana, Pa.

"This would affect almost every bank," he said. "What concerns me is, we would up end with our business dictated by accounting requirements."

Customers would also suffer under the derivatives rule, added Susan Schmidt Bies, executive vice president for risk management at First Tennessee National Corp.

"We use derivatives all the time in mortgage banking in ways that help consumers," she said. For example, the bank uses forward sales contracts- agreements to sell a loan at a future date-to let customers lock in interest rates when they apply for mortgages. The bank uses options to hedge against prepayment risk.

John T. Thornton, chief financial officer at Norwest Corp., made a stark prediction when he testified on FASB's plan before the House Banking Committee's capital markets subcommittee in October: "Mortgage lenders might not offer the lock-in option, and prepayment penalties may become more prevalent."

If the derivatives rule were adopted, BankAmerica would be forced to end one of its primary hedging strategies-entering into swap agreements to offset mismatches between the expected maturity dates of loans and deposits on its books.

Mr. Dixon said accounting for swaps under FASB's proposal could lead to a $150 million swing in earnings with each half-percentage-point change in rates.

Long-term deposits outstrip long-term loans at BankAmerica by $11 billion. That hurts when interest rates fall because borrowers will repay outstanding loans to get a lower rate, while the bank is forced to continue paying higher rates on deposits.

To compensate, BankAmerica enters "floating/fixed" swaps agreements, which generate greater revenue when rates fall.

While FASB's plan would require quarterly adjustments for the swaps, BankAmerica would have to carry deposits at their face value. This is not fair, Mr. Dixon argued, because the market value of the deposit base would move in the opposite direction from the derivatives, counteracting earnings-report volatility.

Consequently, if FASB goes ahead with its plan, it should permit banks to list deposits at their fair market, instead of face, value, Mr. Dixon contended.

"This problem cannot be resolved as long as banks are prevented from offsetting the real changes in the economic value of their deposits against their hedges," Mr. Dixon said.

Robert C. Wilkins, senior manager for FASB's derivatives project, derided bankers' complaints as "disingenuous" and complained that they are trying to kill the entire derivatives initiative.

He also rejected arguments that banks should be allowed to carry deposits at any level other than face value.

"Is it appropriate for a bank to say the value of a $1,000 deposit is only $999?" he said. "The liability is fixed-$1,000 payable on demand."

Mr. Wilkins did not accept that banks would be less willing to use derivatives as a risk management tool. "They will still want to protect against (long-term) risks," he said.

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