FASB to push fair value on bank loans

Private equity firms considering making bank investments in the US should carefully monitor a new proposal expected to be announced by the Financial Accounting Standards Board (FASB), which would force them to adjust the values of bank loans to account for changes in interest rates and credit quality.

Under current accounting rules, banks hold a loan at its original cost to maturity, the FASB proposal – which will be outlined in a discussion draft potentially sometime in the second quarter – would call for all loans to be reported on a bank’s balance sheet at fair value and adjusted for market values and loan-loss reserves. While the rules are intended to help show investors what the loans could be sold for at any balance sheet date, banks are wary of the impact that factors like credit quality and interest rates have on values.

“If you think about it from this example, if a bank loans somebody $100, and it’s in the hold-to-maturity bucket, right now they would leave that on the books as $100,” said Duff & Phelps managing director David Larsen. “That’s how the whole maturity loan is dealt with now. [Under the FASB proposal], let’s say it has a fixed interest of 5 percent, but the market interest rates changed to 6 percent. So interest rates go up, the value of the loan arguably goes down, and so now the loan has gone hypothetically from $100 to $95, so you would now record the fair value at $95 on the balance sheet.”

Larsen said this could affect 40 to 50 percent of the assets of large banks, and community banks may have as much as 80 percent of their assets in loans that would switch from an amortised cost basis to a fair value basis. Since loans issued by a private equity firm are already recorded at fair value, the FASB changes would mainly impact firms investing in banks, which as Larsen points out is a very small percentage of the industry.

That percentage is not likely to get much bigger either, with private equity managers saying that bank investing has become less attractive since the Federal Deposit Insurance Corporation (FDIC) imposed rules that require private equity firms to maintain a higher capitalisation ratio than other entities in order to own a banking institution.

When the FASB proposal is released, it will be subject to a comment period, with one area of focus likely to be its deviation from a stated proposal by the International Accounting Standards Board (IASB) that says a basic loan that has been managed on a hold-to-maturity basis can be held at cost. Both FASB and the IASB have made efforts to reach a common set of financial accounting standards.