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American Association of Bank Directors Calls for Bank Regulatory Capital Relief

September 26, 2008—Bethesda, Maryland

The American Association of Bank Directors ("AABD") has requested the federal banking agencies to count, as part of regulatory capital, the amount of other-than-temporary impairments on investments where the banks have reasonably determined that the obligors are credit-worthy and have the capacity to repay their obligations.

"As the number of banks and savings institutions facing capital adequacy pressures increases just as sources of capital have dwindled, the impact of OTTI on bank regulatory capital requires immediate bank supervisory agency attention," wrote David Baris, Executive Director of AABD.

"Current market conditions are such that the intrinsic value of many of the securities held by banks is materially higher than the market value of such securities as a result of unprecedented disruption in the securities and banking markets," Baris said. "Although GAAP requires write-offs of these intrinsic values in certain circumstances, those values should continue to be counted as regulatory capital if the obligors are credit-worthy."

Under current definitions of regulatory capital, amounts written off a bank's books as a result of an "other-than-temporary impairment" would also have the effect of reducing regulatory capital.

However, most banks own investments with the intention of holding them indefinitely (either in an account called "held to maturity" or "available for sale.") It is our understanding that relatively few banks have significant holdings in a "trading account."

Even though these investments are held with the intention of holding them indefinitely, the accounting profession, in recent years, has adopted accounting principles that require banks and others to write down any investment that has an "other-than-temporary impairment." All investments that have a market value less than the cost to the bank are considered impaired; this then requires the bank to consider a number of factors in deciding whether the particular investment is temporarily impaired or other-than-temporary impaired. Banks are not forced to write off the difference between cost and market for those investments that are temporarily impaired; investments that are other-than-temporarily impaired do require write-offs, which have the effect of reducing regulatory capital.

The problem is that the accounting literature takes into account not just the creditworthiness of the obligor and its financial capacity to repay the obligation as agreed, but also market conditions affecting the market value of the investment.

"Despite repeated efforts by the accounting profession and the SEC to set objective and uniform standards by which to determine whether an impairment ... is 'temporary' or 'other-than-temporary', the process remains highly subjective and the results very uneven", Baris wrote.

AABD is not requesting the federal banking agencies to change GAAP accounting. Instead, it is asking the agencies to allow OTTI that has been written off, based on GAAP, to be counted as part of regulatory capital "if the bank in question applies a reasonable methodology to determine the current sound worth and paying capacity of the obligor and/or of the collateral pledged on the security, and has a current intention to hold the security indefinitely."

AABD also recommended that the agencies change the risk-weighting for Freddie Mac and Fannie Mae debt securities as a result of the U.S. government placing those firms in conservatorship. If these debt securities effectively now have the full faith and credit of the U.S. government supporting them, then they should be moved from a 20% risk-weighting to a 0% risk-rating.

Founded in 1989, the non-profit American Association of Bank Directors is the only trade group in the United States solely devoted to bank directors and their information, education, and advocacy needs. The Institute for Bank Director Education was established in 1993 as the education arm of AABD. Its purpose is to act as a clearinghouse for education programs designed for bank and savings institution directors that support the nationally recognized Director Education Certification Program.

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