Following the high-profile Spring 2023 bank failures, liquidity and capital have become the latest focal points for financial institutions. In the case of those banks that experienced failures in 2023, their large held-to-maturity investment portfolios had significant unrealized losses that had not been recognized through capital previously. While available-for-sale securities (AFS) have the unrealized gain/loss recognized through capital via accumulated other comprehensive income/loss (OCI), the unrealized gain/loss generally does not run directly through the income statement unless there are credit concerns or intent/requirements to sell.
According to an S&P Global Market Intelligence analysis of major exchange-traded US banks, 211 out of 257 banks recorded either percentage or dollar amount decreases in their AFS securities during 2023. In that analysis, 20 institutions recorded year-over decreases in their AFS portfolios ranging from 19% up to 54%. Some institutions have decided to take the pain now, hoping to stabilize the net interest margin and set themselves up for future success. Analysts generally view those banks with high capital ratios selling these securities positively.
Thinking About Selling Investments?
If your institution is considering selling AFS securities in an unrealized loss position, you need to understand the accounting implications. The flowchart below is a starting point to assess whether a credit loss expense needs to be recorded:
In Accounting Standards Codification (ASC) 326-30-35-10, intent to sell is equated with a decision to sell a security. There may also be considerations around whether management will be required to sell the security. Management’s intent may not be explicit to a third party. Therefore, it is essential that management document when and why decisions are made to sell specific securities, including securities sold during the year for liquidity needs.
This may already be part of an entity’s investment sale due diligence documentation, but it should be as explicit as possible. At a reporting period, if management intends to sell or will be required to sell an impaired security, the security’s amortized cost basis should be written down to fair value after writing off any allowance for credit losses on that security.
When an entity sells a security at a loss shortly after a reporting period, questions of intent will likely arise. If a dealer approached management on attractive terms after the reporting period, it is likely no impairment was required at the previous reporting period. Suppose management sold impaired securities in the fourth quarter or a few days after the balance sheet date due to liquidity needs. In these cases, consideration should be given to whether the securities at the balance sheet date should have been written down due to a requirement to sell due to liquidity needs.
Other Considerations
Upon adoption of Accounting Standards Update (ASU) 2016-13 Financial Instruments —Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, the concept of other-than-temporary impairment (OTTI) is no longer relevant. In determining if a credit loss exists, the length of time the security has been impaired should no longer be considered. AFS debt securities do continue to be evaluated individually.
Credit impairment is recognized through an allowance to the security’s amortized cost basis unless the intent or more-likely-than-not requirement to sell exists. That allowance is limited to the excess of the security’s amortized cost basis over its fair value at the reporting date. After credit loss is recorded, subsequent increases and decreases in expected cash flows are recorded as a reduction or increase in credit loss expense. Under the previous OTTI model, subsequent increases in expected cash flows were recognized on a prospective basis as interest income.
Lastly, under ASC 326-30, if a security at the time of purchase has experienced a more-than-insignificant deterioration in credit quality since its origination, an allowance for expected credit losses is recognized through an increase to the security’s initial carrying amount.
Conclusion
If you have any further questions regarding investments and impairment implications, Wolf is here to help. Please reach out to a member of our team for more information.
