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What can we do about financial instruments disclosures?

What can we do about financial instruments disclosures?

Dear Jim:

Thanks for sending me the FASB exposure draft on "Disclosures on Market Value of Financial Instruments." I have reviewed it several times, and have concluded that the ED creates more problems than it solves. It seems to me that the FASB doesn't understand the environment in which community banks, and other small businesses, operate. So I'd like to tell you what problems we will have should the draft become a "generally accepted accounting principle."

Because the issues are so complex, I'll limit my discussion to the liability side of the balance sheet.

Published market prices not available

The ED defines (paragraph 5, page 2) the market value of a financial instrument as "the product of the number of trading units of the instrument times the market price - the amount at which a single trading unit of the instrument could be exchanged in a current transaction between a willing buyer and a willing seller, other than in a forced liquidation sale." But what is a "trading unit" as it relates to deposits, especially to demand deposits, and to core repurchase agreements? And where do we get a market price for a trading unit? I have never seen a published market price for either actual sale transactions or a bid/ask quote estimate as defined by the ED.

The definition assumes that transactions are between a willing buyer and a willing seller, which implies a national market. If this is so, would we be able to select and use the most favorable indexes applicable in any area in the United States? And can we use a different local, statewide, regional, or national index each year as we assess the values and merits of each index?

The size of the market is critical. Even though Lake City is a relatively small community bank of only $300 million in assets, some of our offices are in direct competition with both of the largest financial institutions in Indiana and with large regional holding companies ranked among the largest financial institutions in the United States. Surely the FASB would not require a small community bank to use an index less favorable than the one used by its direct competitors!

Where is the |most active market'?

The ED also states (paragraph 6, page 2) that "the quoted price for a single traded unit in the most active market provides useful information to investors, creditors, and others, and is the basis for determining market price and reporting market value." But where is the "most active market" for the valuation of deposits and core repurchase agreements?

The Resolution Trust Corporation is having a tough time selling deposits, according to reports in a number of business and trade publications. If a national organization such as the RTC can't find a viable national market for the sale of deposits and core repurchase agreements, why does the FASB assume that a small community bank in a non-metropolitan area has the skills and resources necessary to identify national markets and a national value, especially when the FASB expects valuations to exclude all related intangibles normally associated with depository accounts and core repurchase agreements?

The ED also states (in paragraph 11, page 3) that "[i]f quoted market prices are not available, management's best estimate of market values may be based on the quoted market price of a financial instrument with similar characteristics or on valuation techniques (for example, the present value of estimated future cash flows using a discount rate commensurate with risks involved, option pricing models, or matrix pricing models)."

I believe that the RTC's experience indicates an absolute lack of market prices and of meaningful methods of estimating market values. How many small financial institutions have developed or purchased option-pricing or matrix-pricing models applicable to deposit valuations and core repurchase agreements?

I assume that very few, if any, financial institutions have been successful in developing or buying these models. Can I therefore assume that, since there is no practical means to make a realistic market valuation of the deposits and core repurchase agreements held by community banks in non-metropolitan areas, we are automatically excluded from the requirements outlined in this exposure draft?

Further, because there is no quoted market price for deposits and core repurchase agreements of a community bank, how does the FASB define other financial instruments with similar characteristics?

Several years ago, the brokered CD rates might have been considered a crude indicator of potential value of at least some of the financial instruments represented by deposit and core repurchase agreements. But as regulators have taken drastic actions to intimidate financial institutions from using brokered deposits, either as a source of funds or as earning assets, CD rates are no longer even a crude indicator. Thus, the actions of various governmental regulators (SEC, federal banking regulations, and state banking regulators) have destroyed the fundamental premise of this entire ED; namely, that there are transactions between "a willing buyer and a willing seller, other than in a forced or liquidation sale."

The ED goes on to say (in paragraph 12, page 4) that "[i]n estimating the market value of deposit liabilities, a financial entity shall not take into account the value of core deposit intangibles which are separate intangible assets, but not financial instruments."

There are two problems with this statement. First, if a market does exist for financial instruments represented by demand deposits and core repurchase agreements of a community bank, as the FASB assumes in the sections I've already discussed, why does the FASB imply that estimates may be necessary alternatives to obtaining published quotes?

This paragraph clearly indicates that even the FASB knows that its assumptions about a national market for deposits or core repurchase agreements outlined in the ED are not realistic. Second, as far as I know, the sale of financial instruments represented by deposits and core repurchase agreements have always included related intangibles. If indeed this is true, why does the FASB base a theory on the assumption that a sale excluding intangibles is a routine occurrence?

Too big to fail

The FDIC has established the "too big to fail" doctrine. One of the results of that doctrine is that core deposits over $100,000 have a value different from core deposits of less than $100,000. It also creates different values for core repurchase accounts, regardless of amount, held by a small community bank and by a bank that is "too big to fail."

Being a small community bank, we obviously are not "too big to fail." But some of our direct competitors are. What are the FASB standards for recognizing differences between these intrinsic values (as required by paragraph 12, page 4)? If the FASB is correct in assuming reasonably priced option-pricing and matrix-pricing models are available in the marketplace, do those models correctly evaluate all intrinsic values according to this ED? What I'm really asking, of course, is if the FASB will penalize community banks merely because they are not "too big to fail."

Cost of compliance

Another, very significant issue is the cost of compliance. In the last several years, we've done several acquisition analyses that included more than just the valuation of the financial instruments defined in the ED. Each of these projects was costly. But if our accounting firm had had the use of the option-pricing models or the matrix-pricing models that the FASB assumes are ordinary working tools used by all community banks, our cost would have been significantly less.

Does the FASB assume that small community banks have greater technical expertise, equipment, and models than do some of the larger CPA firms? And, for that matter, is the FASB attempting to prevent all small and medium-sized CPA firms from serving small community organizations (both financial institutions and nonfinancial institutions with financial instruments) by requiring a level of expertise that may not yet exist even in the large regional and national firms?

What is practicable?

The ED states (in paragraph 15, page 4) that the determination of market values should be undertaken only where it is practicable - which means that it can be accomplished without incurring excessive costs.

What does the FASB mean by excessive costs? A CPA firm now uses "materiality" to determine if adjustments to a corporation's financial statements are necessary before it can issue an unqualified opinion and, depending on facts and circumstances, "materiality" has been defined at times as less than 5 percent and at other times as 10 percent. Since materiality has already been given such a broad definition, can it be assumed that "excessive costs" are much smaller than material costs? If so, can they be a small fraction of 1 percent?

And would the FASB - or an accounting firm, for that matter - define excessive costs as the same absolute dollar amount for two banks of the same size if one of these banks has a healthy balance sheet and a strong income statement and the other does not? Or would a percentage of net income be the determining factor? And would the answer be the same if these companies were fierce competitors?

Perhaps the most successful community banks are successful because they have devoted less time and resources coming up with theoretical answers to theoretical questions based upon hypothetical assumptions that do not exist in the real world.

Paragraph 15 (page 4) continues with the statement that "it might not be practical for an entity to estimate the market value of a class of financial instruments for which a quoted market price is not available because it has not yet [italics mine] developed or obtained the valuation model necessary to make the estimate and the cost of obtaining an independent appraisal appears excessive considering the significance of the instruments for the entity."

This statement clearly indicates that the FASB assumes a valuation model is available at a reasonable price and that the annual cost of maintaining and updating the model would not be excessive. But I believe that very few professionals, if any, could name the models currently available, the initial cost of each model, and the annual maintenance expense that would be associated with the use of that model.

This looks like a good case of the old "garbage in/garbage out" process. As far as I know, there never have been realistic market prices to evaluate deposits and core repurchase agreements of a community bank, either with or without the intangibles normally associated with those deposits and core repurchase agreements. Thus, we have only garbage to start the process. An expensive model can only process data faster; it can't convert garbage into valuable data.

Community banks

shoulder the burden

Our holding company now has about 670 stockholders. We have been required to submit 10-Q reports and 10-K reports for nearly eight years. But, as far as I can recall, no stockholder has ever requested a copy of our 10-Q report. Frequently only one, if any, of our stockholders requests a copy of our 10-K report in any one year. And I can't recall anyone other than an officer or employee of the corporation or of the bank requesting an explanation of any of the footnotes or the financial disclosures in our annual report.

I would be very surprised if other community banks have had more requests for information from their stockholders than we have. I can only conclude that the FASB proposal represents an academic exercise that would not provide any meaningful benefits to the stockholders of most small community banks.

You indicated that the first issue the FASB is going to bring to its Small Business Advisory Group is the cost/benefit issue. As far as I can see, the only thing the FASB is concerned about is what theoretical analysis it will require small financial institutions to perform in order to minimize or eliminate government regulation of certain segments of the certified public accounting profession. So it seems to me that the costs of avoiding government regulation will be born primarily by small community banks, with no benefits accruing either to their stockholders or to their depositors. In fact, it appears that two competing banks will frequently use different theoretical assumptions and different models to interpret a data base of doubtful economic statistics in order to generate annual reports loaded with theoretical data. If analyses issued by competing banks are not comparable and cannot be understood either by current or potential depositors or stockholders of those banks, will anyone except the certified public accountants and their various trade associations gain from the increased costs?

Worse than loan loss reserve

The problems of estimating a reasonable loan loss reserve have plagued bankers for years. Even though bankers and their accountants have centuries of experience estimating the amount that should appear in the balance sheet as a reserve for loan losses, there still is no agreement on what is an acceptable spread between a high and low reserve. My experience tells me that a spread of 20 to 40 percent is acceptable. But, since the reserve for loan losses frequently is in the range of 1 percent to 2 percent of total loans, the spread between the high and low represents a very small percentage of the bank's total assets, although it is a somewhat higher, but still small, percentage of stockholders' equity.

Needless to say, we don't have centuries of experience in market valuation estimates. But let's assume that the banking profession is able to narrow the gap in market valuation estimates, and that the range in the spread between the high and low market valuations of financial instruments represented by deposits and core repurchase agreements is only 15 percent to 25 percent. Would that range be satisfactory to the FASB and the certified public accounting profession, especially when these financial instruments might represent 80 percent to 90 percent of the entire balance sheet? If not, why does the FASB expect that we have greater skills in developing and implementing these new theories than the accounting profession has been able to develop over the centuries of experience with the loan loss reserve? But, if so, why is a range of that magnitude realistic when very few national and large regional money center banks have stockholders' equity of 5 percent of assets and most community banks have stockholders' equity of 7 percent to 10 percent of assets?

How can we have reasonable assessments of the theoretical market values of selected financial instruments if the spreads between the high and low valuations are substantially in excess of stockholders' equity and yet expect current and potential depositors and stockholders to evaluate theoretical statistical data generated by two competing banks?

This ED is based upon so many erroneous and unrealistic assumptions that I can't see any probability that data published by one community bank would be comparable to data published by its competitor, especially if the competitor belongs to a holding company that is "too big to fail." I can't foresee the public making any sound, logical financial decisions based upon theoretical answers required by this ED.

Let's start over

As I said at the beginning of my letter, this exposure draft creates more problems than it solves. I think the FASB should withdraw the draft until it can come up with realistic solutions to the theoretical problems the draft poses.

If, and when, logical, low-cost methods of evaluating the liability side of the balance sheet are developed, it might be appropriate to develop similar low-cost methods for valuating financial instruments included on the asset side of the balance sheet.


Richard D. Mackey Senior Vice President and Controller Lake City Bank Secretary/Treasurer Lakeland Financial Corporation

PHOTO : Campaign portrait of Abraham Lincoln, lithograph, Currier & Ives, New York, 1860

In this official campaign portrait, Lincoln is shown without a heard, which he grew between his election and inauguration.

PHOTO : Campaign portrait of Stephen A. Douglas, lithograph, E. B. & E. C. Kellogg, New York, 1860.

Lincoln won the election of 1860 because the Democratic party was split. The Northern Democratic candidate was Douglas, of Illinois, who believed that slavery in the territories should be determined by the residents.
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Title Annotation:Corporate Reporting
Author:Mackey, Richard D.
Publication:Financial Executive
Date:Sep 1, 1991
Previous Article:Accounting for income taxes - one more time.
Next Article:Value-added tax: not the tax we need.

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