The rapid rise of interest rates has had a significant impact on the banking industry. One effect has been a rapid deterioration in the market value of investment portfolios.
For financial institutions with securities classified as available for sale (AFS), this has resulted in a decline in equity through accumulated other comprehensive income (AOCI). While these unrealized security losses are not recognized through income unless the losses are determined to be other-than-temporary impairment (OTTI), some institutions have begun to experience unexpected consequences from the declining equity.
Ramifications of increased unrealized losses
When you consider the potential impacts of declining AOCI, you need to distinguish between balance sheet capital and regulatory capital. In 2015, banks were allowed a one-time option to eliminate AOCI from the calculation of regulatory capital under Basel III. Most banks made that election. As a result, changes in AOCI do not impact regulatory capital ratios for these banks. Similarly, credit unions do not include AOCI in their calculation of regulatory net worth.
Some financial institution stakeholders evaluate financial institutions based on their balance sheet capital ratios, which does include AOCI. The Federal Home Loan Bank (FHLB), for example, cannot make a new advance to a member institution whose tangible capital (which includes AOCI) is not positive.
In addition, certain state regulations have capital ratio requirements based on bank capital. Wisconsin state savings banks must maintain a 6% net worth ratio, which is based on balance sheet capital. Other potential impacts of reduced balance sheet capital include possible restrictions on loan sales to the secondary market and reduced borrowing capacity from lenders like the FHLB.
Accounting for transferring securities from available for sale to held to maturity
Given these impacts, financial institutions have been evaluating options for minimizing the impact of the growing AOCI losses. One common strategy discussed has been to transfer AFS securities to held to maturity securities (HTM securities). HTM securities are recorded at amortized cost, with no adjustment for changes in market value unless the losses are OTTI.
There are a few key ramifications associated with transferring securities from AFS to HTM you should consider:
- Securities may be classified as HTM only if your financial institution has the positive intent and ability to hold those securities to maturity: Such a transfer should not be viewed as a temporary measure, as subsequently transferring securities from HTM back to AFS would call into question the intent of management in future investment transactions. Your institution should carefully evaluate whether it truly intends to hold these securities to maturity and has the ability to do so, paying special attention to the duration of those securities and the possible impact of expected economic uncertainty on projected liquidity needs and sources.
- The AOCI as of the transfer date does not go away upon transfer: You’ll need to accrete the unrealized loss remaining in AOCI over the life of the security (this accretion does not ultimately have an impact on net income). While transferring securities will not eliminate existing AOCI, it will limit any additional accumulation of unrealized losses, since unrealized gains and losses accumulated after the transfer are not recognized in AOCI.
- Unrealized losses will be “locked in”: Although unrealized losses will be accreted over the remaining life of the security, your institution will not have an opportunity to reverse those losses or even recognize unrealized gains through AOCI if the market improves.
- Transferring securities to HTM will limit liquidity options moving forward: Other than a few exceptions, HTM securities cannot be sold without tainting the entire HTM portfolio, and therefore do not represent a reliable liquidity source.
- HTM securities must be evaluated for impairment using a current expected credit loss (CECL) model similar to loans: Evaluating securities for impairment under a CECL model will require a different process than the current OTTI model, and that may be time consuming to develop and may also require the recognition of credit loss reserves through net income.
- The decision to transfer securities should not be backdated to previous reporting periods: For example, if your institution has completed quarterly call reports during the year, it should not go back and determine the transfer to HTM was made as of the beginning of the fiscal year and remove the AOCI accumulated year-to-date.
- Your institution does not have to transfer all securities to HTM: In fact, it may be difficult to support your institution’s intent and ability to hold all securities to HTM. However, you may choose to transfer some securities to HTM and leave other securities classified AFS.
Because increased AOCI losses are having a meaningful impact on financial institutions, you should consider not only the ramifications to your financial reporting but also the impact on your ability to conduct business with entities like the FHLB. If your institution anticipates negative ramifications, you can think about transferring securities from AFS to HTM, but your management should consider both the benefits and downsides before making such a decision.
Wipfli recommends institutions consider these factors as part of their overall management of liquidity and the institution itself so that decisions made today do not create bigger problems down the road.
If you have more questions or need assistance working through this challenge, contact Wipfli for help.
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