The impact of rate increases on regulatory capital
We are officially in a rising rate environment.
On March 16, 2022, the Federal Reserve increased interest rates for the first time since December 2018 and indicated there will likely be incremental increases through 2022. As a result, many financial institutions with available-for-sale (AFS) securities are seeing unrealized losses on their investment portfolio escalating at an alarming rate.
The impact of this valuation adjustment is recognized in the equity section of the balance sheet as accumulated other comprehensive income (AOCI). The negative impact of the AOCI decreasing balance sheet capital is causing alarm to financial institution boards of directors and shareholders.
The true impact of unrealized losses on equity capital
It’s important to understand the distinction between balance sheet capital and regulatory capital. AOCI is included in total equity capital on the balance sheet and on financial statements provided to your board and the public. From this perspective, it may appear capital has declined, which could create a legitimate reason for concern. “Capital” is used to calculate key financial indicators, such as the community banking leverage ratio (CBLR), risk-based capital ratios, legal lending limit and Regulation O thresholds.
While you should monitor AOCI, in most cases it has no impact on the “capital” used to calculate the key financial indicators discussed above. Note that, depending on the purpose and the rule-making body, capital may be defined differently. The capital calculation used to determine the CBLR and risk-based capital ratios, completed on Schedule RC-R, Part I of the Call Report, typically does not include the impact of changes in AOCI.
As part of Basel III, financial institutions had the opportunity to make a one-time election to opt out of including AOCI in equity capital on Schedule RC-R, Part I, item 3.a, AOCI opt-out election. The majority did elect to opt out, which eliminates the impact of changes in the fair value of AFS securities recognized through AOCI on the financial institution’s capital used to calculate capital ratios. Since the regulatory definition of capital drives most other regulatory financial indicators, the AOCI should not impact your calculations for the legal lending limit, Regulation O or other key performance indicators.
The impact of reclassifying AFS securities to held to maturity (HTM) to eliminate the impact on capital
In an effort to minimize the negative impact on balance sheet capital, many financial institutions are evaluating whether to reclassify the AFS portfolio to HTM. You should carefully consider the following prior to making this change:
- Since you do not factor the unrealized loss (or gain) into the regulatory capital calculation, there is no impact on regulatory capital unless your financial institution sells the security and realizes a loss. Investments are included in total average assets and the risk-based asset calculation at amortized cost; therefore, you eliminate any unrealized loss from both the asset and the equity sides of the equation.
- Once securities are transferred to HTM, your financial institution loses the ability to sell the security. While many financial institutions have sufficient or excess liquidity today, that may not be the case in the future. It’s important to consider the duration of the securities and the long-term impact on liquidity.
- The current amount of AOCI will become stranded when the portfolio is transferred. You will need to amortize/accrete the unrealized loss and the AOCI to the yield for each security type over the life of the security. If your financial institution has a deferred tax asset, you’ll need to split the accretion proportionately between AOCI and the deferred tax asset. These entries will continue through the life of the security, which may take many years. Since this is not a common practice, your institution should have sufficient knowledge to explain the process to auditors and examiners.
- A reserve for HTM securities may be required under the Current Expected Credit Losses (CECL) methodology. If a reserve were not deemed necessary, your financial institution would need to develop sufficient support for that determination. If a reserve were required, additional reporting and recordkeeping would be required.
The importance of education and communication
Regulatory capital in financial institutions is more complicated than in other industries. High-level training provided to your board of directors to explain the differences between balance sheet capital and regulatory capital will build a foundation of understanding that will assist your leadership with navigating the uncertain future. Including a quarterly review of the Schedule RC-R with directors would refocus the attention on the important financial information.
For clarity, consider modifying the presentation of the financial statements to include separate sections for equity capital and AOCI. While the balance sheet total will still include the AOCI impact, it may be helpful to isolate the equity components that make up regulatory capital.
How Wipfli can help
Remember that your financial institution will experience no actual loss unless the securities are sold. The unrealized loss does not impact the regulatory capital calculation, and education and communication with leadership are critical to effective decision making.
The large increases in unrealized investment portfolio losses can be unsettling. Taking a step back from the panic of the unrealized devaluation of the investment portfolio to evaluate the actual impact on your institution’s financial condition will provide important perspective for making sound financial and strategic decisions.
If you need assistance further clarifying or implementing the above, contact Wipfli. We can help you navigate the impact of rising rates.
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