Fitch Ratings has issued a report on the Financial Accounting Standards Board’s recently unveiled proposal requiring most financial instruments, including loans, to be measured on the balance sheet at fair value.

“This is a profound accounting change that will affect the reported balance sheets of most banks in a very significant way, with possible repercussions on bank analysis and reported bank capital,” said Fitch director Olu Sonola in a statement.

From a regulatory standpoint, it remains to be decided what the capital impact will be. However, the total equity of most banks is set for more volatility, the report contends.
In a December 2009 Fitch study of 20 large commercial banks in the U.S., loans made up 55 percent of total assets, although this figure would be higher for smaller and regional banks. Ninety-eight percent of loans held by the banks were classified as held for investment and therefore measured at amortized cost.

Based on Fitch’s review, if the proposal for loans had been adopted in the third quarter of 2009, it would have resulted in a decrease in shareholder’s equity of $130 billion, or approximately 14 percent of the combined total equity of all the 20 banks reviewed. This reduction excludes the tax effect and the offsets from applying fair value to the liabilities that fund the loans.

While the proposal is silent on disclosure, Fitch believes that an overhaul of disclosures on the fair value of loans is necessary to aid transparency. Furthermore, given the potential for the lack of an active and liquid market for loans, disclosures of meaningful sensitivity analysis, coupled with the methods and significant assumptions used in the valuation process, would be needed to provide a robust and insightful presentation to analysts and investors. 

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