EVE-at-Risk, UGL on AFS, and the tax-deferred adjustment
Originally published 3/25/2014 © 2021 Olson Research Associates, Inc.
Most community banks regularly measure and monitor IRR. Depending on the rate cycle certain modeling practices and assumptions receive more scrutiny than others. Typically when market rates change - bank risk profiles change, sometimes dramatically, so it's important that we regularly and thoroughly inspect IRR modeling techniques. Our current rate environment is no exception and over the past several years we've definitely come to expect more from our ALM models: multiple rate shocks, static vs. dynamic forecast stress-tests, multi-year projections, non-parallel shifts, expanded & more comprehensive studies of core deposit behavior, etc.
One item popping up more these days is the treatment of tax-deferred adjustments for AFS securities when computing EVE-at-risk. It’s easy to see why this is being scrutinized more closely. Our prolonged low interest rate environment continues to lay the foundation for future vulnerability (1). Many banks have been extending asset duration and reaching for yield to combat the squeeze on margin. As they do the potential negative adjustment to equity could be significant when rates begin to rise.
Case study of two approaches
In order to understand the modeling issue better it's best to understand how the accounting works for a bank's AFS securities portfolio. I've created an example case study here. A similar example of accounting entries can be found in the FFIEC's call report instructions (2).
Suppose the fair value of a bank's AFS securities exceeds its amortized cost by $342,000. Since this account must be marked-to-market the book value of assets would be increased by $342,000. If the bank's applicable tax rate (federal, state, and local) is 40% and the tax basis of its AFS securities approximates their amortized cost, the bank would adjust the other side of the balance sheet as follows:
Liability: Deferred Tax of $137,000 [40% x $342,000]
Equity: Other Comprehensive Income (OCI) of $205,000 [$342,000 - (40% x $342,000)]
This follows U.S. generally accepted accounting principles (GAAP), specifically ASC Section 320-10-35 (a.k.a. FAS115)(3). While obviously the amounts differ from bank to bank, thousands of banks make this sort of accounting entry every month. They have been doing this for the past 20 years since FAS115 took effect in December 1993. Since one part of our ALM model (A/L BENCHMARKS) deals with historical reporting, in 1993 we also made a change. We updated modeling procedures to handle the marked-to-market adjustments, including the changes to OCI and deferred tax.
A/L BENCHMARKS is also used to quantify long-term IRR by measuring EVE-at-risk. A first step in calculating EVE-at-risk is to create a present value balance sheet. The question is...should this FAS115 adjustment (specifically the adjustment for deferred taxes) be carried into the EVE-at-risk analysis? The adjustment, whether included or not, can significantly impact the level of EVE-at-risk that's reported. The degree of impact is determined by such factors as the size of the bank's AFS portfolio (relative to total assets), the duration of the bonds, overall equity leverage, and the bank's composite tax rate.
In the example case study EVE-at-risk is calculated using two different approaches. Approach #1 incorporates the FAS115 adjustment for deferred taxes. In the up shock the deferred tax liability actually becomes negative (i.e. it's now a deferred tax asset) due to the projected depreciation in the AFS portfolio. The deferred tax item certainly softens the blow to EVE-at-risk; using this approach EVE-at-risk is reported to be -13.47%.
Approach #2 does not include the FAS115 adjustment for deferred taxes. Instead the entire UGL on the AFS portfolio is applied to equity thereby eliminating any GAAP adjustments. Approach #2 changes the calculated EVE-at-risk noticeably. Instead of -13.47% it is now -22.18%. If the bank's ALCO policy limit is -20% (quite standard for community banks) it certainly matters which approach is used.
A/L BENCHMARKS, by default, follows approach #1 (i.e. we carry the deferred tax adjustment into the EVE-at-risk analysis). We feel that many MTM accounting standards and practices, including this one, seem to logically overlap those used to construct an EVE-at-risk analysis. Indeed FASB has outlined a number of standards and practices for calculating present value that are used extensively by modelers today (see document formerly know as FAS157, now ASC-Section-820-10-55)(4).
Just because we make this adjustment in our model doesn't necessarily mean we think it's absolutely the “right” approach (and that not doing so is “wrong”.) On the contrary, like many things in A/L modeling, we can see pros and cons in both approaches. Over the past month I've personally contacted several industry experts including correspondent bankers, auditors, consultants, and of course examiners regarding this issue. The response has been remarkably divided and seems to come down to accounting conventions versus risk assessment.
All in favor say aye
A/L BENCHMARKS is not the only A/L model to include such an adjustment. Indeed, conversations with senior capital markets examiners from both the FDIC and the OCC confirm they have seen banks that incorporate the adjustment. They also said that, "there appears to be no formal or official regulatory opinion or restriction on the practice of adjusting EVE for deferred tax assets."
I also contacted a colleague who heads-up the ALM correspondent services for FNBB in Baton Rouge. "It's an option we've provided since 2000," says Sheila Tibbetts. Her group provides ALM modeling for several hundred banks across the south. "Over the past fourteen years I have had one or two examiners question why we include it...but it seems a normal extension of the standard (GAAP) information we provide via our bond accounting system." FNBB's ALM modeling platform is SunGard's Ambit BancWare. "Our clients can choose to model it either way."
Another perspective was outlined in a recent webinar presented by Moody's Analytics. It's part of their Stress Testing Webinar Series, this one entitled, "Macroeconomic Conditional Pre-Provision Net Revenue (PPNR) Forecasting." One part of the presentation is about leveraging Balance Sheet Management Systems (including ALM models) for the CCAR stress-tests (5). Here are two of several important points they make about modeling the balance sheet:
Good BSM systems have the ability to natively incorporate "systems accounts" but many banks do not use them fully. Examples include Accrued interest receivable/payable, Accrued principle receivable, AFS/HTM gains and losses/impairment, Charge Offs and Provision, Balancer accounts, Retained earnings, Taxes/Deferred tax liability, and Dividends.
For stand alone applications like pre-trade analytics, IRR quantification, FTP, or capital management, the bare minimum was good enough. However, in CCAR, the regulatory community is saying that BSM needs to more prospective and holistic. Therefore, all of the macro-economic, risk factor, and accounting interrelationships matter.
And finally, here’s a perspective that comes from Deb Donaldson, President & CEO of Alpha-Numeric Consulting. She is the author of a very practical book entitled, "Auditing and Validating Asset/Liability Management Models", published by FMS. "I can see good arguments both for and against including it. Including the adjustment shows that, as of the single point in time, there is some inherent value to the institution." That value is likely to change when market rates change. "On the other hand, the value calculation is as of a certain point in time. The deferred tax balance may represent a future period in which the balance may vary – so there's an argument against." Ultimately she says her inclination is to include it, "although if a client can present an argument for its exclusion that has been accepted by their regulators, I will pass on the comment (with documentation, of course!)"
All opposed say nay
Not everyone agrees with making the adjustment however. I also contacted McGuire Performance Solutions. Their CEO Bill McGuire shares this, "it’s an old question that pops up occasionally. The solution comes from stepping back and aligning the answer with what the regulatory intentions of equity at risk tests are. When TB-13 was written, the goal was to assess what net resolution residual was currently embedded in a thrift’s balance sheet and what happened to that if interest rates changed sharply. We wanted to know – and regulators currently want to know – what economic value (not book value) was present to protect the deposit insurance fund in the event of a forced resolution." Obviously he sees EVE-at-risk as a regulatory risk assessment tool and is not in favor of including the deferred tax adjustment.
Another vote against including the adjustment appeared just last month in an opinion column of the Michigan Banker Magazine (6):
Materially Improper Calculation in One Model
Industry practice in measuring interest rate risk and presenting the results is largely uniform across most models, however, one significant model method is not consistent in that it adds a deferred tax asset created by the calculated loss in value of the investment portfolio. As rates rise, the value of investments correctly falls. However, the model offsets the negative impact of falling investment values by the amount of the deferred tax asset. This leads to a material miscalculation that results in erroneous reports. Recommendation: Do not use a deferred tax asset in your ALM modeling.
So obviously their view is to leave the adjustment out. I think it’s a bit of a stretch to call any model that makes the adjustment “erroneous”. And, as I’ve already pointed out, there are clearly other models that include this adjustment so I’m not sure what to make of the claim that only “One Model” does this.
And what about the regulatory perspective? Not surprisingly, senior capital markets examiners from the FDIC, Fed, and OCC all seem to view EVE-at-risk as a pure risk-assessment measure too. I was fortunate to personally communicate with all three regulators on this issue. Here is a summary of what they conveyed:
They are aware of the question and have discussed it internally (informally) at various times in the past
Their observation is that many banks do not make this adjustment, but it is apparently a practice at some banks.
There is no formal regulatory opinion or restriction on the practice of adjusting EVE for deferred tax assets.
Aside from these points several of the examiners additionally offered there insightful opinions on the matter. One said he thought, “adjusting EVE for any deferred tax benefit would appear to mix an accounting/income event (deferred tax adjustment) with an economic cash flow measurement (EVE), and would seem to be somewhat of an apples/oranges issue.” I think this is a good point and it’s similar to the view offered by McGuire. They also said that they weren’t aware of any specific situations where banks have been criticized for including deferred-tax in EVE. And if a bank were making such an adjustment, they would ask them to consider adopting lower EVE limits to account for its inclusion.
An unclear message
Interestingly however there is indeed official communication from regulators that seems to conflict with this view. Last October the FDIC published FIL-46-2013 entitled, “Managing Sensitivity to Market Risk in a challenging Interest Rate Environment” (7). Its purpose is to re-emphasize to banks the importance of IRR oversight and risk management processes in the face of rising rates. The document is quite short (it’s only four pages), but here’s a quote that I think is particularly germane to this issue:
Examiners will continue to consider the amount of unrealized losses in the investment portfolio and the degree to which institutions are exposed to the risk of realizing losses from depreciated securities when qualitatively assessing capital adequacy and liquidity and assigning examination ratings.
Net unrealized losses on available-for-sale (AFS) debt securities flow through to equity capital as reported under U.S. generally accepted accounting principles (GAAP). Adverse trends in an institution’s GAAP equity can have negative market perception and liquidity implications.
Several times in this short document the FDIC says bankers should play close attention to the potential negative impact on GAAP equity. In fact they cite directly (i.e. “chapter & verse”) the applicable accounting standards, ASC Section 320-10-35 (a.k.a. FAS115) right at the bottom of page 3. GAAP Equity can indeed be impacted by deferred tax and GAAP equity is literally what the FDIC is referring to here. This seems to contradict the views expressed during our conversations.
My two cents
In case you haven't guessed already, I'm in favor of including the adjustment. Another colleague of mine who has been advising banks for 25 years sums it up the best: “the bottom line is...taxes matter. They have value - good or bad. I think EVE should reflect that value. Any banker would tell you that taxes affect their performance." I tend to agree.
Here are three reasons why I think you should include the adjustment:
1) It's consistent with GAAP - When marked-to-market became a reality for the investment portfolio (via FAS115) we changed our reporting and modeling process to account for the FAS115 adjustment to UGL (OCI) and deferred taxes. It's a standard accounting practice that all C-corp banks follow on a monthly basis to adjust their books to reflect investment market values. Since a first step in EVE-at-risk analysis is to create a present value balance sheet it seems logical to continue with the adjustment (again because it follows GAAP) rather than backing it out. It's already quite difficult to convince senior bank management and boards to pay attention to EVE-at-risk. Imagine how much more difficult it would be if they knew that step one was to disregard deferred taxes.
2) It's consistent with other IRR risk metrics - The other popular method of measuring a bank's IRR is earnings simulation or earnings-at-risk. A typical earnings simulation is built upon a one or two year forecast of earnings. The forecast may be a budget, or a strategic plan, or even a flat balance sheet projection. Armed with a base forecast you then stress-test the rate environment and recalculate income. Every forecast of net income I’ve ever seen for a tax paying bank always includes projected income taxes. It seems very inconsistent to include the tax impact in one IRR metric and not the other.
3) It's one step closer to integrating risk management – For several years now the industry has been working toward unified “enterprise-wide” planning and risk measurement tools. Multiple experts and examiners say an ideal risk measurement system is one that is built-in to the planning process. In last month’s “RISK Perspective” Moody’s includes an article that directly addresses this desire for better integration (8):
Regulators would like to see each bank’s stress testing program become more than just a regulatory compliance exercise – it envisions banks using their programs to better inform strategic and business planning, risk appetite, and advanced risk management practices. Many of the primary methodologies described in the Fed’s published documents, however, create a challenge for banks to achieve this vision and appear to be inconsistent with Generally Accepted Accounting Principles (GAAP).
Conversations with chief risk officers and other top executives at larger banks would seem to confirm this dilemma. Banks struggle as to whether they model the stress tests on an accrual accounting basis, which would allow them to best leverage the exercise for their business practices, or model the stress scenarios using the methodology as described by the Fed. Additionally, some are also considering whether they should forecast under both methodologies – reminiscent of when banks had to prepare and report financial results under both GAAP and Regulatory Accounting Principles (RAP) accounting.
If regulators truly want banks to pay closer attention to IRR metrics then promoting shared methodologies would be a good first step.
In our A/L BENCHMARKS model when we calculate EVE-at-risk we include the adjustment for deferred taxes on the UGL for AFS. It’s the default setting for any bank with a composite tax rate greater than zero. Upon request we can easily turn the adjustment on or off and leave it up to you to decide what’s appropriate for your institution.
I’d like to thank all those who offered their comments and opinions to me while working on this article. Some were mentioned and some were not; either way I truly appreciate your (sometimes very thought provoking) insights. If anyone has comments they’d like to share regarding this issue please feel free to contact me.
1) OCC’s Semiannual Risk Perspective for Fall 2013:
2) Instructions for Preparation of Consolidated Reports of Condition and Income (FFIEC 031 and 041):
3) Accounting Standards Codification (ASC) Section 320-10-35, Investments—Debt and Equity Securities-Overall-Subsequent Measurement:
4) Accounting Standards Codification (ASC) Section 820-10-55, Fair Value Measurement – Overall-Implementation Guidance and Illustrations:
5) Stress Testing Webinar Series: Macroeconomic Conditional Pre-Provision Net Revenue (PPNR) Forecasting - January 28, 2014 – Moody’s Analytics:
http://www.moodysanalytics.com/~/media/Insight/Regulatory/Stress-Testing/2014/2014-28-01-Macroeconomic-Conditional-PPNR-Forecasting-Webinar-Slides.ashx (link no longer available)
6) Michigan Banker Magazine (Print Edition) – February 2014
7) FIL-46-2013 -“Managing Sensitivity to Market Risk in a challenging Interest Rate Environment” – FDIC
8) Risk Perspectives - Moody’s Analytics – December 2013
http://www.moodysanalytics.com/~/media/Insight/Publications/2013/2013-20-11-Risk-Perspectives-V02-Stress-Testing-North-American-Edition.ashx (link no longer available)