Capital Markets

Will Bank Regulators Diverge from GAAP?

The FDIC will discuss new accounting rules at its board meeting next week, and once again, the idea of slipping free of bothersome rules is likely ...
Marie LeoneAugust 20, 2009

Bank regulators are set to discuss accounting standards next week, with an aim toward determining the potential affects that off-balance-sheet rules may have on some financial institutions. During the past year, bankers have fretted about new accounting rules that would force them to bring back on their balance sheets billions of dollars worth of assets — a move bankers have argued will throw regulatory capital ratios into chaos.

As a result, the Federal Deposit Insurance Corp., the federal agency that insures bank deposits, announced it would discuss “the impact of modifications to generally accepted accounting principles” during its August 26 board meeting. What that likely means is board members will debate the practical implications of the rules known as FAS 166 and FAS 167, which beginning in January 2010 will change the way banks and other financial institutions account for securitizations and special-purpose entities (SPEs).

The projects that eventually became FAS 166 and FAS 167 were initiated by FASB at the request of investors, the Securities and Exchange Commission, and the President’s Working Group on Financial Markets. The working group was originally formed by then-President Ronald Reagan in response to the “Black Monday” stock-market crash of 1987.

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The new standards revise older accounting rules — specifically FAS 140 and FIN 46(R) — changing the way, for example, companies define control over financial assets and liabilities, thereby causing some off-balance-sheet transactions to be consolidated back on to company financial statements. The rule would likely have a large impact on banks, which frequently package up loans into securities.

The impact of the accounting rules on banks came to a head in May, when the Federal Reserve Board released the results of its so-called stress tests, which were performed on the 19 largest bank holding companies in the United States. The unprecedented stress testing, officially dubbed the Supervisory Capital Assessment Program, incorporated several accounting changes into its modeling, including the potential effects of FAS 166 and FAS 167. In its summary report, the Fed concluded that the new FASB rules would require banks to reconsolidate off-balance-sheet assets tied to securitizations and SPEs.

So far, the estimates of how many billions of dollars would have to be reconsolidated vary, with the Fed guessing that an aggregate $700 billion worth of assets would be brought back on the balance sheets of the largest bank holding companies. News reports have estimated the impact to be closer to $1 trillion worth of assets.

The problem for banks is that as they consolidate the assets, they also will be required by law to increase their capital cushion, something that could prove undoable during a credit crisis.

Banks do have reason to hope, however. While banking regulators usually require GAAP-based reporting from financial institutions, which would include the use of FAS 166 and FAS 167, they can ignore GAAP for regulatory capital purposes. Indeed, that is exactly what happened when banks protested an earlier effort to improve securitization accounting. In 2005, to help quell a bank backlash against FASB’s FIN 46, the Fed announced that accounting rules need not apply to banks.

“Although [generally accepted accounting principles inform] the definition of regulatory capital, the Board is not bound to use GAAP accounting concepts in its definition of tier 1 or tier 2 because regulatory capital requirements are regulatory constructs designed to ensure the safety and soundness of banking organizations, not accounting designations established to ensure the transparency of financial statements,” said the Fed. “In this regard, the definition of tier 1 capital since the Board adopted its risk-based capital rule in 1989 has differed from GAAP equity in a number of ways.”

Thus, there is precedent for holding banks to different standards.

Next week’s meeting at the FDIC will no doubt address the issue of whether banking regulators should avoid FAS 166 and FAS 167 for capital cushion purposes. Bankers are keeping their fingers crossed.

“We do feel the timing of the standards couldn’t be worse,” says Donna Fisher, senior vice president of tax, accounting, and financial management at American Bankers Assn., a trade group. She says the idea of forcing banks to raise large amounts of capital during the current economic crisis “doesn’t make sense.” If bank regulators do require GAAP reporting, then the ABA would like to see the Fed and others mandate a “net presentation” of assets and liabilities for capital requirements, rather than a “gross up” of the items. In that way, regulators would have the gross numbers to assess, but regulatory capital would be based on the bank’s assessment of its risks, rather than all the assets and liabilities it holds. For instance, the gross number would include all the assets and liabilities the bank has a piece of, regardless of whether it sold off a controlling interest to another entity.

But the problem with the net presentation, according to critics, is that before FAS 166 and FAS 167, complex transaction contracts made it difficult to determine who the controlling party was when the owners of SPEs teetered close to bankruptcy. At worst, banks purposely kept the assets off their balance sheet until the vehicle needed to be bailed out at the expense of bank shareholders.

Still, the ABA says banks are not about to start raising more capital until they hear from regulators whether GAAP reporting applies to their regulatory cushion. Ideally, banks would have liked to have seen FASB and bank regulators come out with rules at the same time, notes Fisher.

But since that opportunity has passed, the ABA is lobbying regulators for a three-year transition period if banks are required to use FAS 166 and FAS 167. During the first year, no additional capital would be required, with new capital requirements phased in over the next two years.