Fair value disclosures in a volatile interest-rate climate

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ASU 2016-01 refresher

ASU 2016-01 made substantive changes for equity investments including securities, deferred-tax assets (DTAs) on available-for-sale (AFS) securities, and certain disclosures. The change most relevant to the current discussion is requiring PBEs to use exit price to measure fair value of financial instruments for purposes of disclosure.

Prior to ASU 2016-01, many institutions relied on an exception in U.S. GAAP (Accounting Standards Codification 825-10-55-3), which permitted the fair value of financial instruments to be measured using an entrance price. The ASU eliminated the ability to use an entrance price and required exit price for fair value disclosures. The change created some confusion about how the two approaches differ. Entrance pricing typically was applied to loan portfolios, where the future cash flows would be discounted at rates similar to those for credits being issued to borrowers with similar credit ratings, loan types, and structural terms.

Exit price, however, is based on the price a market participant would expect to receive for the sale of an asset or would pay to transfer a liability, and a market participant’s required rate of return. While this price could approximate recent originations, a market participant incorporates additional considerations in the rate of return that differ from considerations in issuing a credit.

Estimating fair value exit pricing on traditional loan portfolios uses a buildup method. The discount rate is applied to the estimated loan-level cash flows, and then market-based assumptions such as the cost of debt (adjusted for market illiquidity), capital charges, servicing costs, and other identified costs or risks are aggregated to derive a final discount rate. This buildup method produces an exit price for the fair value that incorporates the current risks present for a market participant in a sale or transfer of the financial instruments and their expected returns, which might not be reflected in recent originations.

Why the recent emphasis on fair value disclosures?

The fair value of financial instruments disclosure of a bank balance sheet provides valuable information for users of the financial statements. With the recent adoption of the current expected credit losses (CECL) standard providing a reported metric (that is, allowance for credit losses (ACL)) comparable to the lifetime loss consideration in fair value exit pricing, this disclosure allows for more identifiable comparison between the interest rate and credit composition of portfolio risk that is not present in the balance sheet alone. Analysts also are using the fair value information to adjust tangible capital and identify institutions that might appear to have increased risk from interest-rate movements.

The sharp decline in fair values of loan portfolios seen in the past six quarters is evidence of the potential for fair value movement in the current environment. As a result of interest-rate changes, movement in the median reported fair value declined from approximately par as of Q4 2021 to just above 96% at Q1 2023. At the same time, ACL remained relatively stable, declining from a median of 1.5% to 1.2%. The differences in these changes illustrate the estimated impact of interest-rate risk on portfolios, which can be approximately calculated as the fair value percentage discount minus the ACL percentage. Under this light, a potential rate impact of a 2.8% discount can be seen within portfolios today.

Exhibit 1: SEC filers – reported loan fair value

Source: Crowe analysis, data collected from publicly available public company SEC filings as of May 16, 2023.

Exhibit 2: Median allowance as a percentage of total loans without PPP

Source: Crowe analysis, data collected from publicly available public company SEC filings as of May 16, 2023.

Note: The charts have been accumulated from publicly available information. The process inherently introduces risk of error. Crowe LLP does not warrant this information is error-free. As such, reliance cannot be placed on this information. Users should be aware errors might exist in this chart. This chart is for informational purposes and is not a substitute for legal or accounting advice.

The bottom line is fair value disclosures are in vogue, and institutions need to prepare these estimates expecting additional scrutiny. With the combination of fair value volatility in the current interest-rate environment and recent bank failures, now might be the perfect time for institutions to revisit how they calculate fair value loan disclosures.