A few days ago the board of the Federal Deposit Insurance Corp. proposed a revised approach for calculating deposit insurance assessments on insured depositories with $10 billion or more in total assets. The proposed assessment calculation would include measures that "focus on long-term" risk. An example of such a forward-looking measure is the loss severity measure. It applies a standardized set of assumptions regarding asset recovery values and liability runoff (derived from recent failures) to the institution's balance sheet to quantify the potential loss posed to the insurance fund.
The proposed FDIC assessment approach reflects a broader philosophical move to incorporate more forward-looking measures of risk in supervision and reporting and thereby create a more stable banking system. Other policy proposals have been put forth that are in keeping with this approach. To wit:
- U.S. regulators will likely move forward to institute countercyclical capital planning (i.e., the amount of capital required to be maintained by a bank will increase in times of economic expansion and decrease in times of economic contraction).
- The Basel III framework calls for the establishment of a liquidity coverage ratio sufficient to meet liquidity needs in a high-stress scenario.
- A proposal from the Financial Accounting Standards Board would require banks to set reserves based on long-term loss expectations (expected loss model) as opposed to the current "incurred loss" approach.
- Another FASB proposal on financial instruments would extend fair-value accounting to loan portfolios.
One could debate the merits of each of these proposals, and question whether they will achieve the desired policy goals. What is not debatable is that these proposals are markedly different from previous supervisory approaches in the measurement, discouragement and penalization of risk. They hold significant implications for profitability and regulatory compliance.
Consequently, their implications must be considered in all business planning processes, especially those involving entry into new business lines or expansion plans as early as 2011.