I don’t have much time to post at the moment, but I would like to get some facts out before the issue takes off … and this looks like an issue that will take off.
In a piece picked up by Naked Capitalism, the New York Times reported:
With little notice, regulators at four agencies that oversee the nation’s banks and savings associations on Monday and Tuesday proposed a significant change in accounting rules to bolster banks and encourage widespread industry consolidation by making them more attractive to prospective purchasers. The regulators and the Bush administration have decided to resort to further loosening of the accounting rules to try to get the industry through problems that some experts have attributed in large part to years of deregulation.
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The action by the four banking agencies provides more favorable accounting treatment of so-called good will, an intangible asset that reflects the difference between the market value and selling price of a bank.
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“It’s a desperate thing,” said Karen Shaw Petrou, managing partner of Federal Financial Analytics, a consulting company.“If we’ve learned anything,” she added, “it’s that capital at risk is the way to protect the financial system. Giving any institution a capital incentive to double down the federal backstop would be dangerous.”
Sounds scary, right? Goodwill? Counted as part of Tier 1 Capital? A patent absurdity! Credit Slips has a lot to say, but does not appear to have looked at the source documents.
The Assiduous Readers around here, though, LOVE to look at source documents! Let’s look at the Fed’s press release:
The Federal Reserve Board on Monday requested public comment on an interagency notice of proposed rulemaking (NPR) that would permit a banking organization to reduce the amount of its goodwill deduction from tier 1 capital by any associated deferred tax liability.
Under the proposed rule, the regulatory capital deduction for goodwill would be equal to the maximum capital reduction that could occur as a result of a complete write-off of the goodwill, which is equal to the amount of goodwill reported on the balance sheet under generally accepted accounting principles (GAAP) less any associated deferred tax liability. The proposal is consistent with the treatment of other similar assets.
… and the draft Federal Register Notice:
Under the Agencies’ existing regulatory capital rules, a banking organization1 must deduct certain assets from tier 1 capital.2 A banking organization is permitted to net any associated deferred tax liability against some of those assets prior to deduction from tier 1 capital. Included among those assets are certain intangible assets arising from a nontaxable business combination. Such netting generally is not permitted for goodwill and other intangible assets arising from a taxable business combination. In these cases, the full or gross carrying amount of the asset is deducted.
Statement of Financial Accounting Standards No. 141, Business Combinations (FAS 141), requires that all business combinations be accounted for using the purchase method of accounting for financial reporting purposes under generally accepted accounting principles (GAAP).3 FAS 141 also requires that the acquiring entity assign the cost of the acquired entity to each identifiable asset acquired and liability assumed. The amounts assigned are based generally upon the fair values of such assets and liabilities at the acquisition date. If the cost of the acquired entity exceeds the net of the amounts so assigned, the acquiring entity must recognize the excess amount as goodwill.
Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (FAS 142), prohibits the amortization of goodwill for financial reporting purposes under GAAP and requires periodic testing of the carrying amount of goodwill for impairment.
However, a banking organization generally amortizes goodwill for tax purposes. This difference in treatment generally results in the recognition of a deferred tax liability under GAAP. The deferred tax liability increases over time and is reflected in corresponding reductions in earnings for financial reporting purposes until the goodwill has been fully amortized for tax purposes.
The deferred tax liability generally is not reduced or reversed for financial reporting purposes unless the associated goodwill is written down upon a finding of impairment, or is otherwise derecognized.
The Agencies have received requests from several banking organizations to permit the amount of goodwill arising from a taxable business combination that must be deducted from tier 1 capital to be reduced by any associated deferred tax liability. The Agencies believe that this treatment would appropriately reflect a banking organization’s maximum exposure to loss if the goodwill becomes impaired or is derecognized under GAAP.
Accordingly, the Agencies are proposing to amend their respective capital rules to permit a banking organization to reduce the amount of goodwill it must deduct from tier 1 capital by the amount of any deferred tax liability associated with that goodwill. However, a banking organization that reduces the amount of goodwill deducted from tier 1 capital by the amount of the associated deferred tax liability would not be permitted to net this deferred tax liability against deferred tax assets when determining regulatory capital limitations on deferred tax assets.
The proposed change would permit a banking organization to effectively reduce its regulatory capital deduction for goodwill to an amount equal to the maximum regulatory capital reduction that could occur as a result of the goodwill becoming completely impaired or derecognized. This would increase a banking organization’s tier 1 capital, which is used to determine the banking organization’s leverage ratio and risk-based capital ratios.
Quite frankly, this seems eminently reasonable. I look forward to seeing some contrary opinions in the comments on the draft proposal; but at first blush it looks to me simply like a clearing up of a bureaucratic ‘you can’t get there from here’ rule maze.
At the very least, the New York Times is to be castigated for trying to make this into a Dumb Regulator story. We want INFORMATION, guys! I’ll form my own opinions, thank you!
I haven’t checked yet what the rules are in Canada. I’ll look into it … soon.
Update, 2008-9-30: The official FDIC package on this matter has been posted on their website.
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