The Sky Isn’t Falling, YET!

“Don’t worry.  Unrealized losses on investment securities are just a book entry.  They don’t have any impact on your regulatory capital ratios.  You intend to hold the securities to maturity (or call), so you won’t ever recognize the loss.”

“Those silly mark-to-market rules won’t get any tougher.  The lessons learned from the Lehman failure will prevent any extensions of mark-to-market accounting.”

Not so fast, my friend.  The banking agencies have released a Notice of Proposed Rulemaking addressing implementation of Basel III that includes a summary of the impact of the NPR on community banks.  The biggest impact, by far, is the inclusion of Accumulated Other Comprehensive Income (AOCI) in all regulatory capital calculations.  For those of you who are more than a few years removed from your last accounting class or Call Report seminar, the biggest component of AOCI for most banks is Unrealized Gain/Loss on Available for Sale Securities.

Under the current proposal, AOCI would be phased into the capital calculations 20% per year beginning in 2014, with complete recognition by 2018.  Over that same period, market interest rates are likely to rise, creating a significant unrealized loss in bond portfolios with longer durations.  By 2018, then, bankers could find themselves with less regulatory capital than they expect, at a time when regulatory capital minimums are increasing.  (The impact of Basel III’s higher capital requirements for the big banks and the trickle-down impact on community bank capital ratios is another concern for another commentary.)

The sky is falling!  What do we do!?!  Relax.  You have options.  We can deal with this situation.  Here are a few thoughts, assuming that the current NPR survives the onslaught of critical comment letters you and your banker friends will write (you will write them, won’t you?):

1. We can reclassify some or all of our AFS bonds as HTM and avoid recognizing AOCI
2. We can sell our most price sensitive bonds (hopefully while they have gains) to avoid the price risk and corresponding capital impact
3. We can hope that our most price sensitive bonds (Agency Step-Ups, perhaps) are called before the phase-in makes a significant impact on our capital ratios (probably 2015-2016)
4. We can hold more capital to offset the expected AOCI loss
5. We can move some of our most price-sensitive bonds to our holding company (this one is tricky – ask me for details if you are interested)
6. We can adjust our security purchase strategy to avoid making the situation any worse and let the current portfolio roll inward

I expect there will be a lot of discussion of this topic in coming weeks.  Creative securities dealers will probably come up with some interesting strategies, so don’t rush to solve tomorrow’s problem, today.  Remember – the sky won’t fall until at least 2014 (unless the Mayans were right)…