A proposed change to how banks value loans and other assets on balance sheets might lead to major changes in book value, and possibly impacting capital levels in unpredictable ways.
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The proposal by the Financial Accounting Standards Board (FASB) would require banks to report loans and other financial instruments on its balance sheet at fair value. The FASB is currently accepting public comments on the proposal, and if adopted it would go into effect in 2013.

The FASB itself even recognizes the potential change that this proposal may have, and has included a four year deferral on adoption for non public banks that have less than $1 billion in assets. This would apply to approximately 90% of all banks in the United States, but only 10% of all financial assets. Most banks currently measure the value of their loan portfolio at amortized cost, not fair value. Regulatory filings usually have a footnote disclosing the fair value of loans just for informational purposes.

Advocates of the change argue that it would increase transparency in financial reporting and might provide an early warning on future credit cycles. Opponents feel that it would introduce too much volatility into quarterly results.

Fitch Study
Some analysts have tried to put numbers on the impact of the change if it is implemented. Fitch Ratings did a study and concluded that if the proposal had been in effect for reporting the third quarter of 2009, a decrease of $130 billion in stockholders equity would have been realized. This represented 14% of the total equity of the 20 banks reviewed.

The Fitch Ratings study showed that two of the worst hit banks were Regions Financial (NYSE:RF) and Huntington Bancorp (Nasdaq:HBAN). The fair value of loans for Regions Financial in the third quarter of 2009 was only 81% of book value, while the fair value of Huntington Bancorp's loans were only 87% of book value. The three banks that were least affected were Comerica (NYSE:CMA), BB & T Corp (NYSE:BBT) and U.S. Bancorp (NYSE:USB), which all reported the fair value of loans close to 100% of book value.

It's clear that something needs to be done to improve the area of financial reporting. A recent survey by Price Waterhouse indicated that 47% of the participating financial professionals said that both primary financial statements and disclosures were not "sufficiently useful."

The Bottom Line
The FASB is proposing changes to accounting methods that would depending on your point of view, either make financial statements more transparent and analyzable by the investment community, or create even more volatility in the price movement of bank stocks and the underlying credit cycle. Investors should keep watching this issue as it evolves over the next year. (For more stock analysis, take a look at Finding Growth In Asia.)

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