ABA Comment Letters regarding the FASB Exposure Draft on Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities

In late May 2010, FASB issued an exposure draft "Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities." This document proposes changes to virtually all aspects of bank accounting.

ABA has submitted its comment letter to FASB on August 31. Due to the wide range of issues addressed in the proposal, the comment letter has been split into three parts.  Below is a summary of the different positions taken in the comment letters

Click below to read each of the detailed letters.

1. Classification and Measurement of Financial Assets and Liabilities (and other issues)
2. Credit Impairment of Financial Assets
3. Derivative Instruments and Hedging Activities

As of September 2011, FASB is still discussing the issues. It is not clear when a final standard will be issued or when the standard would be effective. However, based on preliminary decisions made to date, FASB appears to be backing off the proposal to mark loans and deposits to market. Mark to market accounting for debt securities appears to expand with the elimination of Held-to-maturities. No decisions have been made related to loan impairment or to hedge accounting. FASB warns that preliminary decisions can change. Therefore, we recommend you contact ABA for the latest update.

Classification and Measurement of Financial Assets and Liabilities and General Issues:

What the FASB proposal says:

The FASB proposal accounts for all financial instruments (assets and liabilities) at fair value. Changes in the fair value of assets and liabilities that are traded are recorded through net income. Changes in fair value for most loans, debt securities, and financial liabilities that are managed to receive (or pay, as they relate to financial liabilities) contractual cash flows are recorded through other comprehensive income (OCI). An allowance for credit losses will apply to these loans and debt securities and changes to the allowance will be recorded immediately through earnings. Any remaining change to fair value will be recorded through OCI. With that in mind, however, a separate but related proposal has been issued, which will require companies to present only one statement of comprehensive income. This statement of comprehensive income will replace the income statement and will have net income as a subtotal to the new bottom line – Total Comprehensive Income (TCI). TCI will include all fair value changes that are recorded into OCI. To summarize, on a practical basis, FASB is proposing a full fair value accounting model.

What bankers believe the accounting model should be:

Bankers strongly believe that accounting for financial instruments should be based on the business model: Bankers support an accounting model that treats financial statements based on how the company manages the assets and liabilities. Instruments held for trading purposes should be accounted for at fair value, while those held for long-term purposes should be accounted for at amortized cost, with a robust impairment process. See a broad discussion on what bankers believe.

Problems that bankers see with the FASB model

  • Full fair value accounting is not relevant to the commercial banking business model.

Commercial banks are in the business of managing customer credit and customer relationships, and not in managing fair values.  When a borrower has problems, banks don't sell the loan; they work it out with the borrower.  Banking investment analysts agree that fair values are not relevant to this banking model.

  • Full fair value accounting will undermine the reliability in bank capital levels and decrease comparability between banks.

As most commercial loans have no active secondary market, the reliability of recorded loan values (and thus, bank capital) is compromised. Liquidity discounts that are normally required for commercial loans, further reduce the reliability of these amounts as they relate to value to the bank. The value of the individual loan also does not reflect the total value of the customer relationship to the bank that normally performs other services for the borrower.

  • Full fair value accounting introduces complexity where complexity is neither needed nor desired.

Commercial loans make up approximately 60% of commercial bank balance sheets.  These values will now be estimated based on level 3 fair value inputs. Further, the core deposit intangible (CDI) now must be estimated, introducing further complexity. Compounding this is the fact that the CDI is calculated on a different basis than currently used to record it during business combinations.

  • Full fair value accounting will require significant costs to banks with little benefit to users.

Although banking investors have not asked for this information, banks will be required to implement systems to manage these complex processes on a more timely basis and have them audited, which will be costly.

  • Full fair value accounting changes the concept of "comprehensive income" within FASB's Conceptual Framework.

Comprehensive income, within FASB's conceptual framework, has historically been based on how a company manages its business. This significantly changes how FASB thinks about income. Such a change should be subject to a separate and comprehensive review including non-financial assets and liabilities.

  • Full fair value accounting complicates efforts to converge GAAP with IFRS and creates a competitive disadvantage to U.S. banks.

The proposal is significantly different from the recently issued International Financial Reporting Standards Statement No. 9, which accounts for financial assets held long term at amortized cost – not at fair value. Such a difference puts international convergence in doubt and puts U.S. companies at a competitive disadvantage to their international counterparts.

  • Full fair value accounting will add unnecessary procyclicality to the financial system.

Bankers believe that fair value accounting played a major role in exacerbating the financial crisis by its procyclical nature. Expanding fair value accounting will make that situation worse.

ABA has the following comments on other significant areas within the recognition and measurement portion of the ED:

  • Full fair value accounting of a company's own debt distorts performance: gains are realized when company performance declines.

This is a predictable result of fair value accounting.

  • Reclassification of assets and liabilities should be permitted to reflect changes in strategy.

While the proposal eliminates the "tainting" concept of current debt securities accounting, it does not permit reclassification of assets in any circumstance.

  • Cost method accounting should be continued for certain equity investments.
    Certain company financial statements are difficult to obtain on a timely basis, which virtually eliminates the reliability of any fair value estimates that the proposal requires.
  • Current rules for equity method of accounting for equity securities should be maintained.

The proposal to allow equity method accounting only if the investee's operations are related to the investor does not reflect the reality that many companies invest in other companies for strategic purposes that may not be considered related to the company's operations.  In many cases, the fair value (as required in the proposal when the investee's operations are NOT related to the investor's) would not appropriately reflect the value to the investor.

  • Commitments related to credit card arrangements should be excluded from the scope of the ED.

Agreeing with the ED, the fair value of commitments related to credit card balances has values that are unrelated to the financial instrument itself (transaction fees, etc.) and can be terminated by the creditor at any time.

  • There should be consistency in initial measurement.

The ED proposes that transaction costs related to assets used for trading purposes be recorded straight to earnings while those related to assets to be held long-term be deferred and amortized over the expected life of the asset. Bankers believe that transaction costs should be treated the same, no matter the intent on how the asset will be managed.

  • Implementation will be lengthy and costly.

We believe a minimum of four years will be required to implement systems to comply with the proposed requirements.  Since this will affect all existing lending systems, the expected costs are enormous.

  • Other miscellaneous transition issues need to be addressed.

Credit Impairment of Financial Assets

(Review the whole comment letter)

What the FASB proposal says:

A life-of-asset, "expected loss" model is proposed to estimate allowances for loan and lease losses. Losses estimated over the life of an asset, or portfolio of assets, are recorded day one. Triggers to determine that a "probable" loss has "incurred" are taken away. The emphasis is on "How much do you think you will lose?" As part of this, historical loss rates are used as the basis of the expected losses. However, there is an explicit rule forbidding the company to expect that changes in general economic conditions can occur. In other words, unemployment rates are assumed to remain at the same level for an indefinite time period.

Within the FASB model is the requirement to calculate interest income by applying the effective interest rate determined at inception to the amortized cost balance that is determined after applying the allowance for loan losses. Currently, interest is calculated by applying the effective interest rate to the pre-allowance amortized cost.

What bankers believe the impairment model should be:

Bankers support a model that:

  • Recognizes the significant judgment required in the estimation process.

ABA believes that longer time horizons than used in current accounting standards are needed for loss emergence periods, and the use of judgment should be acknowledged and encouraged without strict adherence to probability thresholds. This supports the premises made in the FASB proposal.

  • Considers future expectations of conditions or events that do not exist at the measurement date but are reasonably expected to occur, based on historical experience or other information.

Such expectations would necessarily include national/global macroeconomic trends, community-based activity, as well as borrower-specific information.  This contradicts the FASB proposal, which does not permit an expectation that economic conditions will change in the future.

  • Separates the process of interest income recognition from the process of credit impairment.

Interest income should continue to be calculated based on contractual terms and not on an after-impairment basis. The current standards for nonaccrual loans and charge-offs should also be maintained. This contradicts the FASB proposal, which requires interest income to be calculated on an after-impairment basis.

  • Maintains symmetry in the way increases and decreases of loss estimates are recorded.

For example, increases and decreases in incurred losses should both be recorded immediately through earnings.  This is consistent with the FASB proposal and is a change from current GAAP for certain assets.

  • Recognizes the value of current metrics and analysis by retaining the current principles and methods to record incurred losses.
    • For assets that have been individually identified as impaired under current U.S. GAAP. Expected cash flow forecasts that are defined in the ED appear appropriate for this portion of the portfolio, as this generally reflects the workout and recovery process in managing these assets.
    • For assets that have not been individually identified as impaired, a well-defined process and emergence period is disclosed.

This is consistent with the general direction of the FASB proposal, which calculates expected losses based on individual and on pooled-asset bases.

  • Is operational for community banks

Any impairment must be cost effective for large and small banks.

There must be a world-wide standard as to the definitions critical to the impairment process, such as what constitutes an "incurred loss", an "expected loss", an "impaired loan", and a "nonperforming loan", among others.

There is considerably diversity in how these terms are used world-wide, and common language will allow for greater comparability.

  • Builds upon the current impairment framework, though further recognizes the lower level of precision that estimates of longer-term expected "life of loan" losses compared to shorter-term, incurred loss estimates. Longer-term expected loss estimates are also normally managed within a context of a dynamic "open" portfolio of constantly changing individual loans. Therefore, these distinctions precipitate a difference in how such allowances are identified and may give rise to a different accounting treatment altogether.

We do not at this time recommend how to treat, for accounting purposes, the long-term expected loss provisions for the unimpaired portfolio. While investors we've talked to generally favor knowing management's estimates for the future, when asked about details, there is no consensus on how (or whether) those estimates should be recorded or analyzed. It is also critical, in light of world-wide efforts to redefine regulatory capital, to understand how banking regulators will treat such reserves within their capital calculations.  Finally, given the level of judgment required, how such estimates will be audited is a huge consideration.

We encourage FASB to consider the models being reviewed by an "Expert Advisory Panel" that has been set up by the IASB we are eager to work with them on this.

Derivative Instruments and Hedging Activities

(Review the whole comment letter)

What the FASB proposal says:

The FASB proposal streamlines the hedge accounting process, with the intent that more companies will then perform hedge accounting.

Bankers generally applaud this effort, but have several concerns.

  • Change of the requirement that a hedge is "reasonably effective" (as opposed to being "highly effective") is supported.
  • Shortcut and Critical Terms Match Methods should be maintained, since this helps medium and smaller institutions.
  • Subjective dedesignation should be allowed.

It should reflect how the asset/liability management process actually works, and it is often not practical to enter into a new derivative to discontinue the existing one.

  • Benchmark interest rates must be reconsidered in the new standard.

Companies that wish to hedge the interest rate risk portion of an instrument must apply the hedge accounting rules to either a U.S. Treasury security rate or the LIBOR. Federal funds rate and Prime rates should be considered as comparable to LIBOR, and should be allowed for use.

  • Miscellaneous transition issues must be addressed.

​Contact for further information: ​Donna Fisher, (202) 663-5318, Mike Gullette, (202) 663-4986.