Included in the many proposals recently put forward to fix the banking crisis are several accounting-related ones of which the most prominent are the numerous calls to revise or reverse mark-to-market accounting standards.
In addition, some have suggested that the federal agencies revisit the calculation of regulatory capital. For instance, Paul Haklisch, in a Feb. 11 Viewpoint article, ["Change Rules on Goodwill to Spur Recovery"] proposes that the long-standing practice of completely deducting goodwill from Tier 1 equity be relaxed.
Unfortunately, the economic value of goodwill is not sufficiently reliable to justify its inclusion in capital, and such a change would (initially at least) reward those banks most inclined to overpay for acquisitions. Instead, it would make more sense to address the same punitive regulatory accounting treatment applied to another intangible asset — the core deposit intangible — the asset recorded as the value of the borrowing-cost advantage of an acquired core deposit base.
This intangible asset is truly deserving of recognition for regulatory capital purposes, and a change in its treatment would shore up balance sheets, facilitate consolidation of troubled banks by healthier ones, and more accurately align regulatory incentives with safe and sound banking practices.
In 1993, the four federal bank regulatory agencies adopted a rule codifying the capital treatment of identifiable intangible assets. Under the rule, the agencies determined that purchased mortgage servicing rights and purchased credit card relationships may be included in Tier 1 equity up to certain limits but that core deposit intangibles must be fully deducted from capital. Since the rule's adoption, acquiring core deposits has been qualitatively more capital-intensive than buying mortgage servicing and credit card portfolios.
Of course, if core deposit intangibles lacked the same economic substance as the other intangible assets, its different treatment for capital purposes would be understandable.
But history has proven without question that core deposit intangibles are less risky than their counterparts. There have been two sharp downturns in the banking cycle since core deposit intangibles emerged as an accounting concept in the 1980s. Through both the savings and loan crisis and the current turmoil, stable, low-cost-core deposit companies have maintained their values better than companies emphasizing other intangible assets and, indeed, many regular asset classes.
Furthermore, they are the Federal Deposit Insurance Corp.'s best protection against the dangerous liquidity risks that have manifested themselves recently in financial institutions heavily dependent on noncore funding.
Why then have core deposit intangibles been excluded under the 1993 rule? It states that the agencies evaluate the worthiness of identifiable intangible assets in three ways — the reliability of estimated future cash flows, their ability to be sold separately from the "bank or the bulk of the bank's assets," and the depth of the market for a potential resale of the assets if that ever became necessary.
The regulatory concern the agencies identified in 1993 was a potential lack of a market of sufficient depth for the resale of acquired core deposits, compared to acquired mortgage servicing rights or acquired credit card portfolios.
Purchased mortgage servicing rights and purchased credit card relationships can be sold to both insured depositories and other financial services companies and without geographic limitations, but core deposit intangibles could only be sold to insured depositories and were geographically hampered then by greater restrictions on interstate branching.
Today, the lack-of-marketability concern can be addressed effectively by arranging a forward "resale" of an acquired core deposit base to another buyer. Our company did precisely this as part of an acquisition of a small bank in the Chicago suburbs in 2001. Even today plenty of healthy banks and private investors of the "shelf-charter" variety would be happy to earn a fee now in exchange for the risk that they might be forced in the next few years to buy a nice-looking core deposit base for a good price.
At the time, the regulators were silent on the question of whether core deposit bases generated sufficiently reliable cash flows; since then, the answer that has emerged is a clear "yes."
One understands the agencies' natural reluctance to use their authority to allow a change in regulatory capital accounting that would be advantageous to the banks they regulate. On the other hand, it is very difficult to understand the logic behind the current regulatory capital rule regarding identifiable intangible assets.
Under it, regulatory capital incentives exist that encourage financial institutions to generate and purchase riskier mortgage and consumer credit assets. Simultaneously, the regulatory capital treatment of core deposit intangibles discourages the generation and purchase of stable, low-cost core deposits.