Intangibles Should Count as Capital

What fate do bankers face if they ignore a rule on intangible assets proposed by the Office of the Comptroller of the Currency? The proposal in question concerns treatment of intangibles in connection with capital requirements.

It could help lay the groundwork for failure for some banks, catastrophic change for others. Bankers could find that they have forfeited their opportunity to affect positively the one often-predictable variable in an unpredictable business environment.

When banks make the effort to stay informed about proposed regulation, they gain a better chance to influence the most equitable impact.

If promulgated, the rule on intangibles would affect the amount of capital national banks would be required to maintain. If the final rule excludes or severely limits intangible assets, it would mean higher capital requirements for banks.

Chances to Influence Ruling

If banks want to maintain equitable requirements for capital, then they should make their comments known to the OCC during the comment period. The next chance is the actual proposed rulemaking.

The Federal Deposit Insurance Corp.'s decision on purchased mortgage-servicing rights, on Dec. 12, 1990, had a direct and real impact on the capital of all insured, state-chartered, nonmember banks, as well as on all savings banks and S&Ls.

To ensure fair treatment of identifiable intangible assets (as opposed to all intangible assets) in the calculation of capital for regulatory purposes, we believe that the regulations should consider the following:

* Identifiable intangible assets should be accorded full value in the calculation of the risk-based capital ratio.

* Assets possessing similar risk, tangible and identifiable intangible, should be treated in a consistent manner in the calculation of the risk-based capital ratio.

* Risk assessment should be the only criterion applied to both intangible and identifiable intangible assets in the risk-based capital guidelines.

Grounds for Validity

Generally accepted accounting principles have recognized the validity of intangible assets. They provide substantial guidance for identifying and valuing such assets.

In particular, Accounting Principles Board Opinion No. 17, "Intangible Assets," requires costs to be assigned to all specifically identifiable intangible assets. Further, it states that such costs should not be included in goodwill. The opinion also states that the cost of an intangible asset may not be written off as a lump sum to capital surplus or to retained earnings.

Statement of Financial Accounting Standards No. 72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions," states that intangible assets acquired that can be separately identified shall be assigned a portion of the total cost of the acquired enterprise -- if the fair values of those assets can be reliably determined.

Statement of Financial Accounting Standards No. 65, "Accounting for Certain Mortgage Banking Activities," states that the cost of acquiring the right to service loans should be capitalized as an intangible asset.

Recognition in the Courts

Recent Tax Court cases -- Colorado National Bankshares Inc. and Subsidiaries v. Commission and Citizens & Southern Corp. v. Commissioner -- recognized the validity of identifiable intangible assets. Specifically, both cases affirmed the value of core-deposit intangibles as an identifiable asset -- separate and distinct from goodwill.

In Colorado National Bankshares Inc. and Subsidiaries v. Commission, the court indicated that the core-deposit intangible can be "identified and has a limited useful life which can be estimated with reasonable accuracy." It also can be "valued directly with a fair degree of accuracy."

In Citizens & Southern Corp. v. Commissioner, the court ruled, the bank had demonstrated that the value of the acquired core deposit asset was separate and distinct from goodwill and had a limited useful life. These distinctions permitted the bank to amortize the cost of the core deposits.

The concepts used to value many identifiable intangible assets are similar to those used to arrive at the value of tangible financial assets. In many cases, the value of both tangible assets and identifiable intangible assets is based on the present value of an expected future stream of cash flows.

Ultimately, these values are determined by the market. and are represented by actual prices paid by buyers for tangible as well as identifiable intangible assets. Buyers are willing to purchase identifiable intangible assets because they have value and are expected to provide the investor with a profitable return on his investment.

The value of identifiable intangible assets must be reviewed periodically in accordance with generally accepted accounting principles. The basis for valuing tangible and intangible assets must meet the reliability requirement as discussed in FASB Statement of Financial Accounting Concepts No. 2, "Qualitative Characteristics of Accounting Information."

Assets such as purchased mortgage-servicing rights, deposit base premiums, credit card premiums, and customer lists, are recorded in bank balance sheets as identifiable intangible assets.

However, certain other assets -- similar in nature to the above -- are recorded as tangible assets. These include excess servicing-fee receivables, premiums on investment securities, and premiums on loans purchased.

Despite the different labels, these assets are similar in nature and possess similar characteristics and attributes. These assets should be treated in a consistent manner in the calculation of regulatory capital, in accordance with their risk characteristics.

Under current regulatory practice, most identifiable intangible assets must be deducted directly from regulatory capital. Such assets must be supported by 100% of regulatory capital.

In contrast, the maximum amount of regulatory capital required to support a tangible asset, regardless of risk, is 8%.

The dramatically different treatment is clearly inequitable and unwarranted. Identifiable intangible assets, as well as tangible assets, should be treated in a consistent and straightforward manner based on their risk characteristics.

Qualifying as Capital

Risk-based capital guidelines establish three criteria that identifiable intangible assets must satisfy to avoid being deducted from Tier 1 capital. We believe that the application of these criteria hold identifiable intangible assets to a higher standard than many tangible assets.

In other words, these criteria are too stringent. They do not fairly address the risk characteristics of identifiable intangible assets. Moreover, we believe that several types of tangible assets would not be able to satisfy these very restrictive criteria.

The current three-part test for "qualifying intangibles" is arbitrary and should be abandoned in favor of a direct approach to risk weighting of all assets. Risk assessment should be the only criterion applied to both tangible and identifiable intangible assets in the calculation of the risk-based capital ratio.

We believe identifiable intangible assets have value. They are properly recorded as assets and, therefore, should not be deducted in calculating this ratio.

And assets possessing similar risk characteristics, whether tangible or intangible, should be treated in the same manner in the calculation of risk-weighted assets. If OCC regulators were to draw upon these principles in their deliberations, the result would be the fair and equitable treatment of identifiable intangibles in the calculation of regulatory capital of banks.

If the poet W.H. Auden was correct when he wrote, "Time will say nothing but I told you so," let's listen closely to what the times and the regulatory agencies tell us as we prepare to deal successfully with the future of the world economy. Otherwise, the agencies may be telling us: "I told you so."

Mr. Charles H. Eggleston is a partner with Price Waterhouse & Co.'s financial services industry practice in St. Louis.

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