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Appeal of Supervisory Office Decisions Regarding the Accounting Treatment of the Investment Portfolio, a Provision to the Allowance for Loan and Lease Losses, and the Charge Off of Accrued Interest on a Nonaccrual Loan (Fourth Quarter 2008)

Background

A bank appealed to the Ombudsman the decision by the supervisory office to reclassify its held-to-maturity (HTM) investment portfolio as available for sale (AFS). The bank also appealed the supervisory office requirement to make an immediate provision to the allowance for loan and lease losses (ALLL) of $200,000. Lastly, the bank appealed the supervisory office requirement to charge-off accrued but uncollected interest on a nonaccrual loan.

Discussion

Appeal

The appeal states that the supervisory office conclusion that the bank's HTM portfolio was tainted because it sold securities prior to maturity is inappropriate. Bank management stated that the decision to sell securities from its HTM portfolio was based on the exception in Financial Accounting Standards No. 115 (FAS 115), Accounting for Certain Investments in Debt and Equity Securities. FAS 115 allow HTM securities to be sold prior to maturity under isolated, nonrecurring, and unusual circumstances. Bank management stated that the market conditions that existed at the time of the sale were rare and unusual and could not have been anticipated. The bank was, simultaneously, able to record a significant gain as well as improve bond yield and safety. Management further stated that it would have been remiss if it had not taken advantage of the opportunity.

The bank appealed the supervisory office decision to make an immediate provision of $200,000 to the ALLL because the examiners provided no justification other than “they felt” that it should be closer to the top of the range set by management. The appeal states that the same objective could have been met by increasing the monthly accrual.

Bank management also disagreed with the supervisory office requirement to reverse the accrued interest on a nonaccrual loan. The appeal states that call report instructions do not require the chargeoff of collectible assets and that to do so would be inconsistent with generally accepted accounting principles (GAAP). The appeal further stated that even if the accrued interest chargeoff was required, a portion of the interest could be reversed through the ALLL.

Supervisory Office

The documentation provided to the supervisory office described the sale as “a profit opportunity ... with few negative trade-offs due to recent market chaos.” The bank summarized the transaction as being able to show a significant gain, increase interest income, and improve credit quality. The documentation also discussed how “this highly unusual confluence of market conditions ... seems precisely the type of ‘isolated, nonrecurring and unusual [events] that could not have been reasonably anticipated' as described in FAS 115.” However, after reviewing the safe harbors described in FAS 115 for selling HTM securities without tainting the remainder of the portfolio, the supervisory office did not find the bank's condition surrounding the sale to be compliant with the safe harbors. The supervisory office determined that market volatility is neither unusual nor infrequent and the flight to quality and profit from the sale was not consistent with FAS 115.

The supervisory office found the bank's ALLL methodology established a reasonable range for protection against loan losses. The ALLL balance, at the time of the examination, was at the mid-point of the range. As a result of the examination, 50 percent of the loans reviewed were downgraded, classified assets rose to 48 percent of capital, and credit risk management systems were rated as weak. These factors lead the examiners to request an immediate provision of $200,000 to the reserve; putting the bank at the high end of the range.

The supervisory office directive to charge off the accrued interest associated with a loan on nonaccrual is consistent with call report instructions. The supervisory office, in a separate e-mail after the exam, confirmed the bank's ability to charge part of the accrued interest to the ALLL and to reverse the remaining interest through current interest income.

Conclusion

The Ombudsman reviewed the information submitted by the bank and the supervisory office as well as FAS 115 and call report instructions. Additionally, the Ombudsman consulted with staff at the Financial Accounting Standards Board (FASB) and other OCC units such as Market Risk, Credit Risk, and the Chief Accountant's office.

In regard to the bank's appeal of the requirement to reclassify its HTM portfolio to AFS, the Ombudsman concurred with the supervisory office. Selling HTM securities prior to maturity for profit and/or enhanced bond yield and safety is inconsistent with FAS 115. The exception to FAS 1115 that allows for the sale of HTM securities prior to maturity describes events that are specific to the bank, not to the financial markets. The market conditions that existed at the time of the sale did not meet the definition of isolated, nonrecurring, and unusual. Nor were they specific to this bank. It is not uncommon for market imbalances to occur during the life of securities that create scenarios for significant gains or improved yields. Therefore, the sale of HTM securities prior to maturity tainted the entire portfolio and must be accounted for as AFS, consistent with FAS 115.

With regard to the immediate provision of $200,000 to the ALLL, the Ombudsman found that the supervisory office request was reasonable. The number of credit downgrades, increasing delinquencies, administrative weaknesses, and deteriorating real estate market conditions support the need for an immediate provision to the ALLL rather than an increase in monthly accruals. The credit risks identified during the examination were currently in existence and not potential future occurrences. Therefore, it is appropriate to increase the reserve balance to compensate for the existing risks. The reserve balance should continue to be adjusted through monthly accruals or lump-sum provisions as conditions warrant.

With regard to the appeal of the reversal of accrued interest on a nonaccrual loan, the Ombudsman concurred with the supervisory office. The call report instructions and GAAP require charge-off of accrued interest on a nonaccrual loan when the collateral balance is insufficient to support both principal and interest. Such was the case for the loan in question. The Ombudsman concurred with bank management that a portion of the interest could be reversed through the ALLL because the bank allocates for accrued but uncollected interest in its reserve analysis. The remainder of the interest should be charged to current year interest income.