A small group of banks could suffer from wild swings in income under a new accounting rule.
The Financial Accounting Standards Board last week passed a rule, set to go into effect in 2018, requiring companies to record gains and losses from equity investments on their income statements. While most banks will hardly notice a change, the rule could create volatility for 50 to 70 institutions, mostly mutuals, that have such investments on their books, industry experts said.
"It's terrible," said Menzo Case, president and chief executive of the $285 million-asset Generations Bank in Seneca Falls, N.Y., adding that the rules will introduce "significant" volatility to his bank's earnings. "Someone sneezes in China and the equity markets go crazy."
Generations' equity portfolio accounts for about 10% of its total assets, according to data compiled by Bankdataworks.com.
Most at-risk banks were formed more than a century ago and hold grandfathered authority to invest in equities, said Bob Davis, an executive vice president at the American Bankers Association. While most affected institutions will be small Northeastern mutuals, the rule could also snag other community and regional banks that were allowed to invest in stocks under their initial charters, Davis said.
The new rule will challenge certain business models by introducing volatility to their balance sheets and capital levels, said Davis, who is having conversations with federal regulators in hopes of securing some leeway so that affected institutions aren't "blown out of the water" by such volatility.
The rule – part of a much broader overhaul to accounting standards announced last week – was widely hailed by the banking industry.
The FASB, as part of the changes, scrapped a controversial rule known as the debt-valuation adjustment that bankers have long linked to distorted quarterly earnings. As a result, banks will be able to exclude changes in the value of certain debt, including bonds, structured loans and other securities, from their net income.
"Management does not like to have things on that line that they cannot control," said Roman Weil, a professor emeritus of accounting at the University of Chicago.
The overhaul also has language that bars companies from categorizing equity portfolios as "available for sale." That is problematic because banks with equity investments record valuation adjustments on "available for sale" securities as "other comprehensive income" rather than net income, industry experts said.
"It's not like their balance sheets are loaded with equities, but it will be more than an insignificant number," said James Kendrick, vice president of capital and accounting policy at the Independent Community Bankers of America, adding that most banks with equity investments hold blue-chip stocks.
The ICBA and ABA said they are working with banks that will be hurt by the rule.
"Equities aren't a significant part of banks' portfolios, so we really didn't take sides on this one" component of the new rule, said Michael Gullette, the ABA's vice president for accounting and financial management.
The change could force some banks to retool their balance sheets.
Generations Bank, for instance, is mulling plans to divest and reduce its equity holdings.
"We're going to have to slowly and carefully eliminate" the bank's portfolio to eliminate volatility, Case said, adding that the rule will force other banks to revamp their long-term investment strategies.
"We've held equity securities since the beginning of time," Case said. "It's just another way to kill small banks."
The FASB made the changes to give shareholders a better sense of how companies' equity investments are performing, Larry Smith, a member of the group’s board, said in an emailed statement. It "simplified the accounting for equity investments without reducing the information that investors need to understand and analyze those investments," he added.