As expected, the recent increase in interest rates has negatively affected debt security fair values. For institutions with significant available-for-sale (AFS) debt securities, the result is a notable impact on comprehensive income and equity. Some institutions are considering transferring AFS debt securities to the held-to-maturity (HTM) category, but transfers have accounting and potential liquidity implications to be considered prior to transfer.
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The Federal Reserve Board’s decisions have significantly increased the target federal funds rate in a short period of time.1 Due to the inverse relationship between market interest rates and debt security fair value, increases in interest rates result in debt security fair value declines.
Accounting Standards Codification (ASC) 320-10-35-1 requires an entity to measure AFS debt securities at fair value with unrealized gains and losses recorded in accumulated other comprehensive income (AOCI). In contrast, HTM debt securities are measured at amortized cost. In light of the accounting differences, an institution might contemplate transferring AFS debt securities to HTM.
Institutions need to evaluate two key accounting requirements before a transfer decision (the following information does not address the allowance for credit losses under ASC 326):
ASC 320-10-25-1(c) specifies debt securities can be classified as HTM only when the “entity has the positive intent and ability to hold those securities to maturity.” ASC 320-10-25-4 clarifies example situations that would conflict with an entity’s intent and ability if the entity anticipates the security would be sold due to any of the following:
Crowe observation: Management should consider all relevant factors in assessing its ability and intent at the date of transfer. For example, if management believes future changes in interest rates would cause the entity to sell the security, it would be difficult to assert the intent and ability to hold the security to maturity. Sales of HTM securities call into question an entity’s intent to hold other HTM securities to maturity (a “taint”), absent the specific circumstances listed in ASC 320-10-25-9. Tainting the HTM portfolio generally results in the inability to use the HTM designation for a time.
Entities that transfer debt securities to HTM continue to report the unrealized gain or loss at the date of the transfer in AOCI (ASC 320-10-35-10(d)). AOCI at the date of the transfer is accreted or amortized over the remaining life as a yield adjustment, similar to any other premium or discount (see ASC 320-10-55-24 for an example of how the transfer affects interest income over time). To illustrate the “date of transfer,” if the entity transfers an AFS debt security to HTM on Jan. 31, 202X, that is the date on which the unrealized gain or loss is measured and amortized over the appropriate period. The transfer of a security is not retroactive to any prior date.
An entity that transfers AFS debt securities to HTM should refer to the disclosure requirements of ASC 220-10-50-5 and 320-10-50-9(d), which might require separate disclosure of the impacts in the statement of comprehensive income. Also, it should remember the statement of cash flows and the requirements of ASC 230-10-50-3 for noncash transfers.
An institution with unrealized losses on AFS debt securities also might need to consider liquidity impacts. Section 1266.4 of the Federal Housing Finance Agency (FHFA) regulations sets limitations on an institution’s access to advances from the Federal Home Loan Bank (FHLB) system:
A [FHLB] shall not make a new advance to a member without positive tangible capital unless the member's appropriate federal banking agency or insurer requests in writing that the [FHLB] make such advance. The [FHLB] shall promptly provide the FHFA with a copy of any such request.
Section 1266.4 also states that the FHLB can renew existing advances to institutions with negative tangible capital-day periods, although a federal banking agency or insurer could request that the FHLB not renew the advance. In addition, the FHLB can renew existing advances to an institution with negative tangible capital for a period longer than 30 days at the written request of a federal banking agency or insurer. Here is an illustrative computation of tangible capital:
Total bank equity capital
Less: Total intangible assets
Plus: Mortgage servicing rights (MSRs)*
Less: Disallowed MSRs*
= Tangible capital
* Tangible capital generally is calculated in accordance with GAAP less intangible assets, except for purchased MSRs that are included in the institution’s core or Tier 1 capital.
Crowe observation: Call report instructions for “Schedule RC-R – Regulatory Capital” define all components of Tier 1 capital.
Institutions might be “without positive tangible capital” prior to contemplating a transfer of securities with unrealized losses from AFS to HTM. Because the unrealized loss in AOCI is frozen when a transfer occurs, a transfer will not have an impact on tangible capital. Consequently, institutions could be precluded from borrowing additional funds or renewing existing advances through the FHLB advance program, which could have potentially significant liquidity impacts.
For company management and directors, rising market interest rates are top of mind. Key considerations include:
Crowe observation: A decision to transfer AFS debt securities to HTM locks the unrealized loss at the date of transfer and might preclude the institution from recognizing future increases in fair value if interest rates decline.
Whether interest rates rise or fall in the future, management and boards should consider the accounting and liquidity impacts. Decisions made today can have lasting accounting and disclosure implications.
1 Board of Governors of the Federal Reserve System (U.S.), “Federal Funds Target Range – Upper Limit [DFEDTARU],” retrieved from FRED, Federal Reserve Bank of St. Louis, January 29, 2023, https://fred.stlouisfed.org/series/DFEDTARU
