Manage your bank, not your model

Valuing non-maturity deposits is a huge road-block to implementing fair value accounting

Whether you are for or against full mark-to-market accounting for community banks, I think you’ll agree that it will have a big impact.  In the bank lobby’s tug-of-war with FASB you might say it’s a good thing when a regulator chimes-in in-favor of the banks’ position.  One Fed Governor has done just that:

Fed Seconds Fair-Value Plan Critique
American Banker, Tuesday, September 15, 2009 (subscription required)

WASHINGTON — Federal Reserve Board Gov. Elizabeth Duke sharply criticized key aspects of a pending accounting proposal that would expose a bank's assets and liabilities — including loans held to maturity and deposits — to fair-value treatment.

In a rebuke Monday to the Financial Accounting Standards Board, Duke echoed industry complaints that the approach fails to recognize how banks conduct operations and could cut off credit to small businesses.

Here is one of the main points made by Duke (as quoted in the article):

Duke appeared more concerned about financial institutions' ability to comply with the rule — "We have very little actual experience in fair-valuing liabilities," she said — and its impact on small banks…"Smaller banking companies likely will incur substantial costs and experience great difficulty in applying the new standards," Duke said. "But will financial statement users see any real benefit?"

While I applaud her observations, I think the point about “very little actual experience in fair-valuing liabilities” can’t emphasized enough. 

I don’t think the financial world-at-large truly understands the magnitude of the problem – especially when it comes to valuing non-maturity deposits.  A fundamental piece of any fair value analysis is the timing of the future cash flows.  What timing are you going to use for checking, savings, and money market accounts?  Those of us who make a living modeling interest rate risk know that there isn’t an easy straight-forward answer to this question and, so far, there surely is no standard we can all agree on.

To give you an idea of how big this issue is – a typical bank funds 30% to 50% of their assets with non-maturity deposits.  That’s a pretty big chuck of the balance sheet to be marking-to-market using level 3 inputs.

Discount Rate construction

Our senior analysts are often asked how we construct the discount rate we use to calculate loan (and deposit) fair values.  The Fair Value Disclosure section of our A/L BENCHMARKS Executive Report sums it up pretty nicely.

For a given balance sheet category, the model will employ one of two techniques to construct the discount rate. They are the Build-up approach or the Risk Premium approach.

Build-up Approach
The Build-up approach views the discount rate as consisting of four possible components:

First the Risk-Free Rate forms the foundation of the discount rate and is derived from the Treasury yield curve. It is the point on the Treasury yield curve which corresponds to the maturity structure for future principal and interest cash flows. A geometric interpolation is used between the discrete points of the yield curve to approximate the curvilinear shape of the yield curve. Thus the values of this component vary across time to reflect the term structure of interest, while the remaining components are constant across all time periods. This component also includes an adjustment to reflect the value of imbedded prepayment options.

Next the Credit Risk component is the annualized yield needed to cover the loss of value expected over the entire life of a portfolio. For loans, the derivation of this component is based on an analysis of underperforming loans and the gross charge-off experience of the past four quarters. For funding sources, the derivation of this component is based on financial ratios that reveal the “credit-worthiness” of the financial institution for which present values are being computed. In both cases, the higher the credit quality component, the higher the credit risk.

Next the Operating Expense component represents an annualized cost rate derived from operating expense allocations. This component is used to adjust the risk-free rate in order to compensate for operating expenses. When dealing with core deposits, the operating expense component is reduced by a service charge component (see below).

Finally the Service Charge component represents an annualized income yield derived from operating income allocations. It is used to reduce the operating expense component.

Risk Premium Approach
The risk premium approach views the discount rate as the sum of two components: the risk-free rate, and a risk premium. The risk-free rate is the same as defined above. The Risk Premium is the annualized yield needed to cover the risk reflected in the portfolio. It incorporates all forms of risk in a single spread to the treasury yield curve. Consistent with an entry rate concept of selecting a discount rate, the marginal pricing rate for each account serves as the basis for determining an appropriate risk premium to the Treasury yield curve. This risk premium is calculated by subtracting the value on the curve which corresponds to the average maturity of the account from the account’s marginal pricing rate.

I notice that we published this nearly ten years ago in our old “Communicator” newsletter.  The approach is still the same, although we have updated the weightings and allocations in the Credit Quality and Operating Expense components with newer statistical data.

Mark-to-Market: Fair in Theory, But of What Value?

I’m glad to see the financial press is focusing more on the downside of mark-to-market accounting for banks.

Mark-to-Market: Fair in Theory, But of What Value?
American Banker, September 8, 2009 (subscription required)

I was a little disappointed in the author’s answer to the direct question: “Which aspects of fair value have been most damaging to banks?”:

The real damage to banks occurred when they had certain investments or commitments that were risky and that ended up working out very poorly. Disclosing it is just really telling the world exactly what happened.

But fair value is a costly compliance issue. Where it also could be costly is if you misinterpreted the standard to mean that you really have to use the most recent market price, even if the market price was less than fair value because the market was inactive or because there were distressed sales…

While I agree with these points, it misses a huge problem: marking assets to market - but ignoring liabilities.  Writing down capital and earnings due to changes in asset values while ignoring the tremendous stability (and therefore value) of community bank core deposits just makes no sense.

Overall I don’t agree with using mark-to-market accounting for the entire balance sheet anyway, but if you’re going to use it, apply it equally to both sides of the balance sheet.  Isn’t that why they called it a “balance” sheet in the first place?