Appendix A Excerpts from FASB ASC No. 320, Investments - Debt and Equity Securities The FASB Accounting Standards Codification material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, PO Box 5116, Norwalk, CT 06856-5116, and is reproduced with permission. 320-10-25-1 At acquisition, an entity shall classify debt securities into one of the following three categories: a. Trading securities. If a security is acquired with the intent of selling it within hours or days, the security shall be classified as trading. However, at acquisition an entity is not precluded from classifying as trading a security it plans to hold for a longer period. Classification of a security as trading shall not be precluded simply because th entity does not intend to sell it in the near term. b. Available-for-sale securities. Investments in debt securities not classified as trading securities or as held-to-maturity securities shall be classified as available-for-sale securities. c. Held-to-maturity securities. Investments in debt securities shall be classified as held-to- maturity only if the reporting entity has the positive intent and ability to hold those securities to maturity. 320-10-25-3 Amortized cost is relevant only if a security is actually held to maturity. Use of the held-to- maturity category is restrictive because the use of amortized cost must be justified for each investment in a debt security. At acquisition, an entity shall determine if it has the positive intent and ability to hold a security to maturity, which is distinct from the mere absence of an intent to sell. If management's intention to hold a debt security to maturity is uncertain, it is not appropriate to carry that investment at amortized cost. In establishing intent, an entity shall consider pertinent historical experience, such as sales and transfers of debt securities classified as held-to-maturity. A pattern of sales or transfers of those securities is inconsistent with an held-to-maturity. A pattern of sales or transfers of those securities is inconsistent with an expressed current intent to hold similar debt securities to maturity. 320-10-25-4 An entity shall not classify a debt security as held-to-maturity if the entity has the intent to hold the security for only an indefinite period. Consequently, a debt security shall not, for example, be classified as held-to-maturity if the entity anticipates that the security would be available to be sold in response to any of the following circumstances: a. Changes in market interest rates and related changes in the security's prepayment risk b. Needs for liquidity (for example, due to the withdrawal of deposits, increased demand for loans, surrender of insurance policies, or payment of insurance claims) c. Changes in the availability of and the yield on alternative investments d. Changes in funding sources and terms e. Changes in foreign currency risk 320-10-25-5 Specific scenarios in which a debt security shall not be classified as held-to-maturity (or where sale or transfer of a held-to-maturity security will call into question an investor's stated intent to hold other debt securities to maturity in the future) are as follows: a. A debt security that is available to be sold in response to changes in market interest rates, changes in the security's prepayment risk, the entity's need for liquidity, changes in foreign exchange risk, or other similar factors shall not be included in the held-to-maturity category because the possibility of a sale is indicative that the entity does not have a positive intent and ability to hold the security to maturity: A debt security that is considered available to be sold as part of an entity's asset-liability management activities shall not be classified as held-to-maturity. Similarly, an entity that maintains a dynamic hedging program in which changes in external factors require that certain securities be sold to maintain an effective hedge would not have the intent and ability to hold those securities to maturity. b. The sale of held-to-maturity securities to meet regulatory capital requirements will call into question an investor's stated intent to hold other debt securities to maturity in the future. An entity's ability and intent to hold securities to maturity would be called into question by the sale of held-to-maturity securities to realize gains to replenish regulatory capital that had been reduced by a provision for loan losses. Gains trading with held-to-maturity securities to meet an entity's capital requirements is inconsistent with the held-to-maturity notion. 320-10-25-6 The following changes in circumstances may cause the entity to change its intent to hold a certain security to maturity without calling into question its intent to hold other debt securities to maturity in the future. The sale or transfer of a held-to-maturity security due to one of the following changes in circumstances shall not be considered inconsistent with its original classification: a. Evidence of a significant deterioration in the issuer's creditworthiness (for example, a downgrading of an issuer's published credit rating) b. A change in tax law that eliminates or reduces the tax-exempt status of interest on the debt security (but not a change in tax law that revises the marginal tax rates applicable to interest income) c. A major business combination or major disposition (such as sale of a component of an entity) that necessitates the sale or transfer of held-to-maturity securities to maintain the entity's existing interest rate risk position or credit risk policy d. A change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the maximum level of investments in certain kinds of securities, thereby causing an entity to dispose of a held-to-maturity security e. A significant increase by the regulator in the industry's capital requirements that causes the entity to downsize by selling held-to-maturity securities f. A significant increase in the risk weights of debt securities used for regulatory risk-based capital purposes 320-10-25-9 In addition to the changes in circumstances listed in paragraph 320-10-25-6(a) through (f). certain other events may cause the entity to sell or transfer a held-to-maturity security without necessarily calling into question (tainting) its intent to hold other debt securities to maturity. Such events must meet all of the following four conditions to avoid tainting its intent to hold other debt securities to maturity in the future: a. The event is isolated. b. The event is nonrecurring. c. The event is unusual for the reporting entity. d. The event could not have been reasonably anticipated. 320-10-25-10 Other than extremely remote disaster scenarios (such as a run on a bank or an insurance entity), very few events would meet all four of those conditions. 4. According to the FASB, how should banks decide whether to classify a given debt investment as trading, AFS or HTM? Do you think banks use significant judgment in this classification decision? Explain why or why not. 5. If a bank wants to avoid volatility in its regulatory capital, which investment classification would be the most desirable, and which investment classifications would be the least desirable? Does your answer differ depending on whether the bank is large or small? 6. Once a bank chooses to classify a given investment as HTM, can it subsequently change that classification? What are the potential consequences of selling an HTM investment before maturity in order to meet liquidity needs or to meet regulatory capital requirements? 7. Explain how you would expect banks' debt investment portfolios to change over the time period you are examining in this case (2009-18). Appendix A Excerpts from FASB ASC No. 320, Investments - Debt and Equity Securities The FASB Accounting Standards Codification material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, PO Box 5116, Norwalk, CT 06856-5116, and is reproduced with permission. 320-10-25-1 At acquisition, an entity shall classify debt securities into one of the following three categories: a. Trading securities. If a security is acquired with the intent of selling it within hours or days, the security shall be classified as trading. However, at acquisition an entity is not precluded from classifying as trading a security it plans to hold for a longer period. Classification of a security as trading shall not be precluded simply because th entity does not intend to sell it in the near term. b. Available-for-sale securities. Investments in debt securities not classified as trading securities or as held-to-maturity securities shall be classified as available-for-sale securities. c. Held-to-maturity securities. Investments in debt securities shall be classified as held-to- maturity only if the reporting entity has the positive intent and ability to hold those securities to maturity. 320-10-25-3 Amortized cost is relevant only if a security is actually held to maturity. Use of the held-to- maturity category is restrictive because the use of amortized cost must be justified for each investment in a debt security. At acquisition, an entity shall determine if it has the positive intent and ability to hold a security to maturity, which is distinct from the mere absence of an intent to sell. If management's intention to hold a debt security to maturity is uncertain, it is not appropriate to carry that investment at amortized cost. In establishing intent, an entity shall consider pertinent historical experience, such as sales and transfers of debt securities classified as held-to-maturity. A pattern of sales or transfers of those securities is inconsistent with an held-to-maturity. A pattern of sales or transfers of those securities is inconsistent with an expressed current intent to hold similar debt securities to maturity. 320-10-25-4 An entity shall not classify a debt security as held-to-maturity if the entity has the intent to hold the security for only an indefinite period. Consequently, a debt security shall not, for example, be classified as held-to-maturity if the entity anticipates that the security would be available to be sold in response to any of the following circumstances: a. Changes in market interest rates and related changes in the security's prepayment risk b. Needs for liquidity (for example, due to the withdrawal of deposits, increased demand for loans, surrender of insurance policies, or payment of insurance claims) c. Changes in the availability of and the yield on alternative investments d. Changes in funding sources and terms e. Changes in foreign currency risk 320-10-25-5 Specific scenarios in which a debt security shall not be classified as held-to-maturity (or where sale or transfer of a held-to-maturity security will call into question an investor's stated intent to hold other debt securities to maturity in the future) are as follows: a. A debt security that is available to be sold in response to changes in market interest rates, changes in the security's prepayment risk, the entity's need for liquidity, changes in foreign exchange risk, or other similar factors shall not be included in the held-to-maturity category because the possibility of a sale is indicative that the entity does not have a positive intent and ability to hold the security to maturity: A debt security that is considered available to be sold as part of an entity's asset-liability management activities shall not be classified as held-to-maturity. Similarly, an entity that maintains a dynamic hedging program in which changes in external factors require that certain securities be sold to maintain an effective hedge would not have the intent and ability to hold those securities to maturity. b. The sale of held-to-maturity securities to meet regulatory capital requirements will call into question an investor's stated intent to hold other debt securities to maturity in the future. An entity's ability and intent to hold securities to maturity would be called into question by the sale of held-to-maturity securities to realize gains to replenish regulatory capital that had been reduced by a provision for loan losses. Gains trading with held-to-maturity securities to meet an entity's capital requirements is inconsistent with the held-to-maturity notion. 320-10-25-6 The following changes in circumstances may cause the entity to change its intent to hold a certain security to maturity without calling into question its intent to hold other debt securities to maturity in the future. The sale or transfer of a held-to-maturity security due to one of the following changes in circumstances shall not be considered inconsistent with its original classification: a. Evidence of a significant deterioration in the issuer's creditworthiness (for example, a downgrading of an issuer's published credit rating) b. A change in tax law that eliminates or reduces the tax-exempt status of interest on the debt security (but not a change in tax law that revises the marginal tax rates applicable to interest income) c. A major business combination or major disposition (such as sale of a component of an entity) that necessitates the sale or transfer of held-to-maturity securities to maintain the entity's existing interest rate risk position or credit risk policy d. A change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the maximum level of investments in certain kinds of securities, thereby causing an entity to dispose of a held-to-maturity security e. A significant increase by the regulator in the industry's capital requirements that causes the entity to downsize by selling held-to-maturity securities f. A significant increase in the risk weights of debt securities used for regulatory risk-based capital purposes 320-10-25-9 In addition to the changes in circumstances listed in paragraph 320-10-25-6(a) through (f). certain other events may cause the entity to sell or transfer a held-to-maturity security without necessarily calling into question (tainting) its intent to hold other debt securities to maturity. Such events must meet all of the following four conditions to avoid tainting its intent to hold other debt securities to maturity in the future: a. The event is isolated. b. The event is nonrecurring. c. The event is unusual for the reporting entity. d. The event could not have been reasonably anticipated. 320-10-25-10 Other than extremely remote disaster scenarios (such as a run on a bank or an insurance entity), very few events would meet all four of those conditions. 4. According to the FASB, how should banks decide whether to classify a given debt investment as trading, AFS or HTM? Do you think banks use significant judgment in this classification decision? Explain why or why not. 5. If a bank wants to avoid volatility in its regulatory capital, which investment classification would be the most desirable, and which investment classifications would be the least desirable? Does your answer differ depending on whether the bank is large or small? 6. Once a bank chooses to classify a given investment as HTM, can it subsequently change that classification? What are the potential consequences of selling an HTM investment before maturity in order to meet liquidity needs or to meet regulatory capital requirements? 7. Explain how you would expect banks' debt investment portfolios to change over the time period you are examining in this case (2009-18)