Banks are likely to react to a new Financial Accounting Standards Board standard requiring them to mark most securities to market by shifting a portion of their holdings in fixed-rate mortgage-backed securities into shorter-term Treasury instruments or less risky government or agency securities, according to a study by Big 8 accounting firm Ernst & Young.
Moreover, a shift to market accounting by banks could make their earnings more volatile and have an immediate earnings impact, the study said.
The study does imply that the doomsday scenario it is depicting will occur only if banking regulators go along with the FASB standard and ask institutions in their risk-based capital guidelines to incorporate the changes in their call reports.
But that may not occur, the report said. "It now appears that the impact on capital volatility resulting from market value fluctuations is in the hands of the banking regulators," it said.
"If the regulators exclude unrealized gains and losses from the definition of risk-based regulatory capital, the volatility issue will be mitigated and banks can implement their investment strategies accordingly," the study continued. M would be a reasoned approach to minimize the implications of applying market value accounting to only some assets and no liabilities.
In general, institutions would shorten the life of their securities portfolio by shifting a portion of their holdings in fixed rates mortgage-backed securities to either U.S. Treasury notes or other U.S. government and agency securities." E&Y said in its study. Since banks are the biggest buyers of mortgage-backed securities, their reduction in holdings could result in lower demand - and therefore lower prices for these securities."
The study cautions that "unless new buyers are found or existing market participants' demand for these securities increases, the lower prices may continue, likely forcing originators of mortgages to raise rates, which would ultimately be passed on to the consumer in the form of higher financing costs - increased mortgage rates, increased fees or both.
The study was based on a survey of chief financial and chief investment officers in 216 financial services institutions throughout the country.
In essence, FASB's proposal would require institutions to mark to market a portion of their assets, while ignoring any offsetting market-value adjustment to related financial liabilities.
The fact that only one side of the balance sheet is being valued at market value is what is leading the banking industry and its accountants to complain that the proposal is a "piecemeal" approach to more accurate bank financial statements.
But one of the greatest supporters of FASB on the issue is Rep. Henry B. Gonzalez, D-Texas and chairman of the House Banking Committee. In a paper that was included in the study. Gonzalez discounts the current system as "once-upon-a-time accounting."
One of new standard's key impacts, the study said, will be "The increased financing costs that could ultimately result in a decrease in consumer demand for fixed-rate mortgages."
The majority of institutions with total assets greater than $1 billion responded that they would try to reduce volatility in capital through increased hedging activity, and a fairly high percentage are still deciding, the study said.
"Of particular concern, however, was the response from institutions with total assets of less than $150 million," E&Y said. "Over one-third of these institutions indicated that they were either undecided or would increase hedging activity in response to the FASB proposal.
"This could lead to safety and soundness concerns, as institutions of this size typically do not enter into hedging transactions nor have the expertise to monitor these transactions," the study said.
Volatility in capital is a particular problem for banks because the Federal Deposit Insurance Corp. Improvement Act of 1991 requires bank regulators to take certain actions and restrict bank activities based on an institution's capital level.
"The capital volatility that may result from the FASB proposal also could result in an immediate earnings impact in the form of higher FDIC insurance premiums, which are based on an institution's capital level," the study said.
For example a one-day swing in interest rates at year end that caused a "well capitalized" bank, with $10 billion in insured deposits, to fall to "adequately capitalized." could cause the bank's premiums to increase by $1.5 million for the next six months. This is a real cost (FDIC requires cash payments), in addition to the many other regulatory implications.
Many banks will likely protect themselves from this risk by either reducing potential capital volatility (by shortening the life of their securities portfolio or increasing hedging activity) or maintaining a larger "capital cushion."