The Financial Accounting Standards Board (FASB) last month proposed an overhaul of accounting standards that would require U.S. banks to record their loans at current market value, giving investors a clearer picture of the banks' financial standing.
The proposal is an effort to tighten banking regulation and improve financial transparency, and coincides with Congress finalizing financial reform.
News of the possible policy change prompted this reader to weigh in on what its enforcement, which has been pushed back to as late as 2013, could do for the banking industry:
"Convergence" between U.S. accounting practices and international accounting practices (from the International Accounting Standards Board) is to be implemented in one year. As part of this convergence, U.S. banks must soon begin to revalue (lower) assets on their books at current market value (mark-to-market).
In response, it is highly likely that banking institutions will be forced to build up additional reserve capital to meet federal requirements. In the process, banks could be expected to tighten up some more on credit and issue even fewer loans. More banks could fail.
Mark-to-market accounting will reduce the leeway banks have in valuing loans. Previously, loans that were expected to be held for a long time didn't need to be valued at market value, because any market fluctuation was expected to be made up during the loan duration. Banks already use mark-to-market, or fair value, accounting for stocks and mortgage bonds with values that fluctuate in daily trading.
The FASB will require banks to value loans at both fair value and at amortized cost in a compromise addressing the needs of both regulators and investors.
The FASB and the American Bankers Association are now in a debate over whether or not the rules will help or hinder the banking, lending and investing.
While some big investment banks like Goldman Sachs Group, Inc. (NYSE: GS) and Morgan Stanley (NYSE: MS) already use mark-to-market accounting, regional and community banks that specialize in commercial loans could take a big hit under the new practices. Banks are worried that valuing loans at fair value could mislead investors if banks show big losses during lower market cycles, when in reality those loans would pay off in the long-term.
"This is a terribly destructive idea to even propose," William Isaac, former chairman of the Federal Deposit Insurance Corp., told Businessweek.
Banks like Regions Financial Corp. (NYSE: RF) and KeyCorp (NYSE: KEY) could suffer the biggest negative impact as they have the widest gaps between the carrying value and fair value of loans. Regions carried loans at a mark 15% higher than fair value and KeyCorp's were 12% higher, according to a study analyzing the banks at the end of the first quarter.
"This is a dramatic departure from past practices, and we caution it has the ability to create increased volatility in earnings and equity," wrote analyst Jason Goldberg of Barclay's Capital. "One of our hopes coming out of the past couple of years was to reduce the pro-cyclicality of bank earnings. These proposals appear to take a step in the opposite direction."
The American Bankers Association (ABA) issued a statement warning that the standards would cause problems for the entire economy.
"If implemented, the proposal would greatly undermine the availability of credit by making it difficult to make many long-term loans, the value of which, even if performing perfectly, would likely be reduced on the day a loan is made," said the ABA.
The FASB argues the new standards are for the investors' benefit. If banks would recognize their losses quickly, it would bolster investor confidence and give a more accurate representation of banks' financial standing.
So will these new standards destroy the industry? Will banks limit lending and derail a recovering credit market? Money Morning Contributing Editor Martin Hutchinson says the future of bank lending might not be clear, but the effect of the accounting standards will not be nearly as dramatic as banks claim.
"This is one of the uncertainties facing banks currently, but already they are not doing much lending because they find it more profitable to borrow short-term money and invest in long-term Treasuries or housing bonds," says Hutchinson. "Commercial and industrial lending is down 25% from September 2008, according to Federal Reserve stats, and it's still dropping. So while I expect there will be individual banks for which new accounting standards will make a substantial difference, I don't think it will make much difference for the banking system as a whole. To get lending restarted and restore the integrity of the capital market, we need the Fed to raise interest rates by at least 2% - 3%."
The Fed has hinted that it might almost be time to raise rates, but has yet to announce a timeline to do so.
Banks have until the end of September to comment on the proposed changes before the FASB makes a final decision. If passed, banks with less than $1 billion in assets would have four years to comply with the new standards.
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News and Related Story Links:
FASB Plan Would Force Banks to Report Loan Fair Value
FASB Plan Is "Destructive Idea," Ex-FDIC Chief Says
- The New York Times:
Proposed Overhaul of Accounting Standards Contains Mark-to-Market Rule
- American Bankers Association:
ABA Statement on FASB Exposure Draft
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