July 2012

FASB Issues Proposed ASU on Liquidity and Interest Rate Risk Disclosures

On June 27, 2012, the Financial Account Standards Board (FASB) issued an exposure draft amending Topic 825 – Financial Instruments, entitled Disclosures about Liquidity Risk and Interest Rate Risk. With this exposure draft, the FASB continues its objective to enhance disclosures with respect to the risks inherent within the reporting entity. This initiative began in 2010 with the issuance of ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, which expanded disclosures with regard to credit risk. The new exposure draft addresses two additional types of risk, those of liquidity and interest rate.

While the proposed disclosures in this exposure draft are expected to apply to all entities, the greatest impact will be felt by financial institutions – which, under the proposed ASU, are defined as entities which derive their primary income from the difference between interest income and interest expense (net interest income), as well as entities which provide insurance. In fact, of the more than 30 paragraphs pertaining to new disclosures in this proposed ASU, over 15 new disclosure requirements are specific to financial institutions, both public and nonpublic.

What does the FASB have in store for future reporting by financial institutions?

Liquidity Risk Disclosures

The FASB’s intent with the proposed liquidity risk disclosures is to provide the users of financial statements with information which the FASB feels is necessary to understand the risk that an entity may not be able to meet future financial obligations. To that end, the disclosures addressing liquidity risk are centered on the concept of upcoming maturities of financial liabilities, and their correlation with the maturities of financial assets. To achieve this, the FASB has introduced the concept of “expected maturity” which is defined as “the expected settlement of the instrument resulting from contractual terms.” Though seemingly simplistic on first glance, the entity must also factor in the impact of call dates and prepayment expectations of financial instruments to judgmentally determine the expected maturities. These considerations must be disclosed in the financial statements in a narrative format.

The expected maturity is then used to create a tabular “liquidity gap analysis” which groups the various classes of financial assets and liabilities together into intervals of maturities, which are specifically defined in the proposed guidance in varying degrees of granularity through the end of the fifth subsequent fiscal year, as well as a total for all maturities occurring thereafter. The resulting table will provide the users of financial statement with the amount of any excess or deficit of financial assets over financial liabilities in the specified interval. This analysis will then be supplemented by a narrative discussion of significant changes in the timing of expected maturities over the preceding reporting period, as well as actions taken by management during the current period to address these changes in liquidity, if any.

To supplement the liquidity gap analysis, financial institutions will be required to provide an analysis of time deposit information, including brokered deposits, which discloses the amount of such deposits issued during each of the last four quarters, along with the weighted average yields and weighted average contractual lives. Financial institutions will also be required to provide a table disclosing all available funds – consisting of cash, cash equivalents and high-quality liquid assets – as well as any unused borrowing capacity. From a risk perspective, “high quality liquid assets” refers to financial assets which could easily be liquidated, and if so, have a high probability of paying when required. The FASB’s intent with these disclosures is to have the issuing entities provide the users of financial statements with information on how the issuer will be able to address any deficiencies in liquidity as disclosed in the liquidity gap analysis table.

Interest Rate Risk Disclosures

As previously noted, this exposure draft defines a financial institution as an entity which relies on net interest income as its – to paraphrase – “bread and butter.” If so, then no discussion of risk could be complete without the proposed disclosures respective to interest rate risk, which are intended to provide the users of financial statements with a full discussion of the impact of fluctuations in market interest rates on a financial institution’s financial assets and liabilities.

The proposed disclosures include a “repricing gap analysis” table, which lists the carrying amounts of financial assets and liabilities by class. This analysis will break down the carrying amounts of these financial instruments into the same intervals used for the proposed liquidity disclosures, by using the respective repricing dates. The disclosure will also provide the weighted average contractual yield for each class of asset or liability repricing in that interval. Currently, the exposure draft does not address how financial assets and liabilities which reprice based upon common market metrics such as the LIBOR or Prime interest rates will factor into the calculation of the weighted average contractual yield. Lastly, the table is required to provide the duration for each class of financial instrument, which represents the weighted average length of time until the entity will either pay or receive a cash interest payment on an instrument.

The proposed disclosures will also require an “interest rate sensitivity analysis” which requires an entity to estimate the effects of specifically defined hypothetical changes in interest rates – such as parallel, flattening and steepening shifts in the yield curve – on net income and shareholders’ equity. It is important to note that this analysis is required to reflect the impact of these changes on the financial assets and liabilities as of the reporting date. No consideration should be given to projections with regard to growth rates or changes in asset mix. The analysis should reflect what the impact of these changes in yield curve will be on the financial institution’s currently existing financial instruments – i.e., if business continued to be conducted “as-is.”

Comment Period

The FASB has requested specific feedback from both users and preparers of financial statements, which generally equates to the preparers’ anticipation of any obstacles to their ability to provide the information requested in the above disclosures, as well as the usefulness of the information from the users’ perspective. Comments are due to the FASB by September 25, 2012. A copy of the exposure draft, along with instructions on how to provide comments, can be found by clicking on the link below.

Exposure Draft - Disclosures about Liquidity Risk and Interest Rate Risk

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