Both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Committee (IASC) are moving toward full market-value accounting. In general, the desire for the use of market values instead of the existing historical cost base is driven by the need to observe, analyze, and understand risk (market, price, and interest-rate risks in particular).
The time of full market-value accounting appears to be close at hand. Bankers, accountants, and analysts must agree upon a standard approach to determining fair value. Agreement about concepts, methods, and techniques is especially needed for financial instruments that are not actively traded in a public financial market. Trading market values or acceptable reference market values are available for investment securities and a few other items, such as derivatives, traded long-term debt, and some loans. For non-maturity deposits and many loan portfolios (particularly in the vast majority of smaller banks), traded market values are not available.
In June 1997, the FASB moved toward resolving questions about methods for determining fair value in an exposure draft of a proposed Statement of Financial Accounting Concepts, “Using Cash Flow Information in Accounting Measurements.” In summary, “This Statement provides a framework for using future cash flow as the basis for an accounting measurement….It also provides a common understanding of the objective of present value in accounting measurements.”
For fair values based on discounted cash flows, there must be agreement among bankers, analysts, accountants, and regulators about the concepts, assumptions, and methods used to estimate the cash flows and the discount rates. The model used here (and described in the “*Benchmarks” *article) uses techniques that are consistent with those in the FASB’s proposed concepts statement on using cash flow information.
Fair values that are computed, instead of taken from the market, must be verifiable and believable. The present-value computations must be repeatable by objective their-party referees, the fundamental data used by the computations must be verifiable, and the assumptions must logically fit with industry knowledge and norms. The standard measurement model presented here produces a full present value balance sheet and can produce detail reports about the computations, data, and assumptions.
In addition, computed fair values must be consistent with information about financial market prices and interest-rate movements over time. The standard measurement model presented here produces fair values consistent with market data. *Exhibit 5* presents data related to the fair values reported from the model: the market-value premiums over historical cost value for marketable securities; present-value premiums over carrying values of loans; book-value premiums over present values of deposits; and economic value of equity as a percentage of book value of equity.
The data in *Exhibit 5* are for six quarters beginning with the fourth calendar quarter of 1995 and ending with the first calendar quarter of 1997. The data are for a peer group of banks with total assets of more than $300 million. Data for other peer groups are presented in our quarterly Industry Reports.
*Market value of securities*
The first data presented in *Exhibit 5* shows the market-value premium over the amortized cost of investment securities. The market values for investment securities (both held to maturity and available for sale) are traded market values as compiled from market information and reported by bankers. Naturally, the reported market-value premiums and losses reflect what can be objectively verified about market interest rates and prices.
As interest rates rose during early 1996, bond prices fell. The premiums of market values over cost also fell. As rates flattened or fell slightly during the fourth quarter 1996, bond prices rallied some and premiums increased. The mean value for the premium was 1.1% for fourth quarter 1995 and at 0.4% for the first quarter 1997. The lowest premium in an individual bank was actually a loss of -4.7% in the second quarter of 1996; the highest premium was 20.6% in the first quarter of 1997.
*Present value of loans*
*Exhibit 5* also shows the premium of the fair value over the carrying value of total loans. The premium for each loan portfolio is the calculated present value minus the carrying value (book value less allocated reserves). The premiums were collected for all loan categories for each individual bank and accumulated to serve as peer information.
When the present-value premiums of loans, as report in *Exhibit 5*, are for the same banks for which the market-value premiums of investment securities is reported, the loan fair values pass the test of comparability to the market values of investment securities. The mean values of the calculated present-value premium of loans follow much the same pattern as the market-value premium of investment securities (*Exhibit 5*). If the calculated fair values of non-traded loans can continue to show comparability to the movements of market prices for traded financial instruments, many will be more accepting of the relevance and usability of fair-value measurements for accounting recognition and reporting.
The cash flow estimates of the current model are based upon current balances, fixed/variable-rate classifications, amortization definitions, maturity dates, and prepayment assumptions. The discount rates are daily rates from the U.S. Treasury yield curve adjusted by a risk premium that reflects allocated operation expenses and a credit-quality factor. The discount rates have passed the test of bankers as reasonable estimates of current offering rates. The resultant fair-value estimates have passed the test of auditors who were faced with implementation of SFA no. 107, “Disclosures about Fair Value of Financial Instruments.”
*Present value of deposits*
*Exhibit 5* also shows the premium of the book value over the fair value of total deposits. The premium for each deposit portfolio is the book value minus the calculated present value (bond type value as opposed to franchise value). The premiums were collected for all deposit categories for each individual bank and accumulated as peer information for the six quarters ending March 31, 1997.
The present-value premiums increased from on year-end to the net for the median and the mean for the peer group. This increase in deposits premiums primarily reflected the increase in interest rates on the long end of the U.S. Treasury yield curve during 1996. The pattern of the mean of the deposit premiums is the mirror image (reverse) of the pattern of the premiums for loan present values and premiums for investment securities market values, that is, when asset values go up, liability values go down. In addition to the verifiability of the data, assumptions, and computations, the model produces fair values consistent with information about actual purchases and sales of bank deposits and branches.
**Note:** ^{1}A computer-assisted search by topic in the *American Banker* from 1989 to 1996 produced 54 news accounts of branch or bank sales when deposit information was provided. The articles provided the date, names of banks selling, names of banks buying, the amount of deposits, and the amount of premium paid for the deposits. |
A casual review of 54 branch or bank sales between 1989 and 1996^{1} shows information about the market for bank deposits and branches. The review found that 35 of the transactions were Resolution Trust Corp. (RTC) assisted and 19 were unassisted. It also found that 47 of the transaction were large (more than $100 million), which means the give-a-take negotiations probably reflect well-founded approaches to valuation.
The deposits premium paid on the above transactions was higher (on average) for transactions executed without the assistance of the RTC. The mean of the deposit premium for the non-assisted transactions was 5.78%. The mean of the deposit premium for the assisted transaction was 2.69%. It can be concluded that the RTC-assisted transactions were made an arm’s length value, which represented the cost of alternative funding (or “bond value of deposits”). Further, it can be concluded that a 3.0% incremental franchise-value premium exists over and above the alternative funding cost, as evidenced by the unassisted free-market negotiations.
Although there are timing differences in the numbers (and therefore different market conditions), the 2.69% mean of the reported non-assisted sales is similar to the mean reported in *Exhibit 5* as the present-value premium for deposits in the banks included in Peer Group C. Over the six quarters reported, the average of the mean values is 2.05%. If of any significance, the difference between the 2.69% and the 2.05% may suggest that the industry norm used to estimate the time period for the core deposit decay used by many of the banks in the study is too short. A longer “duration,” or average life estimate, of core deposits will produce a lower liability present value and, therefore, create a larger core deposit premium.
*Economic value of equity premium over book value of equity*
One of the criticisms of market-value accounting has been that it would create a confusing and irrelevant volatility of equity. Such does not appear to be the case, however. For the present value of equity premium over book, the peer group statistics in *Exhibit 5* show stability over time. For the banks in this study, as the present values of assets and liabilities fluctuate, gains tend to offset losses and create only minor fluctuations in equity. This stability of equity suggests that these banks are well balanced or have assets with characteristics that match quite closely the characteristics of their liabilities, that is, the asset values are well hedged.
The model determines the present value of equity (economic value of equity) by subtracting the present value of liabilities from the present value of assets. The collective result of the present-value calculations does not take into account the value of the franchise but only considers the economic present value of the future cash flows. Franchise value, on the other hand, reflects the added business value of the customer base and other market considerations above and beyond the net valuation of discounted assets and liabilities. As with the deposit present-value premium compared to book the cash flow discounting process does not attempt to evaluate the value that may be assigned to the portfolio due to unique markets, unique customer relationships, supply quantities, or alternative demands.
The economic value of equity may not reflect market capitalization value. The trading price of common (or preferred) stock on any day is influenced by many things other than fundamental economic value of the sum of the net present value of the collected individual portfolios. On the other hand, the economic value of equity provides a rational focus for evaluating the potential impact of adverse-rate and financial-market price movements. |