A banker and a thief walk into a bar…

The banker says to the thief, “you’re doing it all wrong. There isn’t any money in what you do.” Smugly, the thief says, “Wanna bet? I have a job this Friday and I’ll show you just how much money I can make.”

The banker laughs and says you're on. The thief, figuring he was just going to rob the banker's vault, figured he could teach this guy a lesson while enriching himself. Friday comes and the thief busts into the bank and demands the teller open the vault. The teller, without hesitation, opens it and to the thief's dismay, there was only 10 dollars in the vault.

The next week the banker and thief meetup at the bar again. The banker asks how the job went and the thief says,” I only made 10 dollars.” The banker says, “I'm glad you learned your lesson, it's a lot easier to rob people when you own the bank.

Obviously, this is a joke. I don’t think banks rob people. However, I do think there was some truth in that joke. And that truth is this…banks do not hold as much cash as people think. And why would they? Banks earn money on the spread. They take in deposits, paying interest to the deposit holders, maybe, and make loans charging borrowers more interest than they pay on the deposits. And, if there’s any money left over, they make investments.

But what types of investments do banks hold? In this episode of GAAP Chats, we’ll discuss the types of investments held by banks using Silicon Valley Bank as an example and how these investments are accounted for under U.S. GAAP. 

Note: The following content is NOT a full transcript of episode 12 of GAAP Chats. To hear the episode in it's entirety, please click here.

Chris: Welcome back, Mike. How was your trip?

Mike: Cold and wet. I went to northern California and let’s just say they’ve had a little bit of precipitation!

Chris: Yeah, they’re really getting hammered, but at least their reservoirs have filled up. So, what are we talking about today?

Mike: Banks.

Chris: Didn’t you listen to last week’s podcast that Bob and I recorded? We already talked about banks!

Mike: Of course I listened. Thanks to Bob for filling in for me by the way. But you guys spent a lot of time on Credit Suisse and the issues it was having, spending half the episode on the material weakness related to the Statement of Cash Flows (which is one of your favorite topics). You briefly mentioned, at a high level, the types of investments held by banks, but I wanted to dig a bit deeper into the investments held by Silicon Valley Bank and how they’re accounted for under U.S. GAAP.

Chris: OK. I’ll allow it. 

Mike: Gee thanks. So, let’s get into it. Back in the day, you'll remember, many banks did have risk\y investments. But thanks to reforms, that is not the composition of a bank's investment portfolio today. As of December 31, 2022, Silicon Valley Bank had total assets of $211.8 billion, of which $120.1 billion related to investment securities, on a consolidated basis. That's a lot of investments, which means the bank didn't have cash to make loans, but that is a problem for another day (or a previous podcast). Looking at their balance sheet, this $120 billion of investments was broken out as follows:

• $26.1 billion of available-for-sale securities
• $91.3 billion of held-to-maturity securities
• $2.7 billion of non-marketable and other equity securities 

Chris: What’s the difference between available-for-sale and held-to-maturity securities?

Mike: Great question! Well, first let’s make something perfectly clear; Both of those categories contain debt securities, or bonds. You cannot hold equity securities in either of those classifications. We’ll get into the specific bonds held by SVB in a moment, but the bank held $117.4 billion of bond investments. That’s 97.8% of all investments and 55.4% of total assets! Therefore, in this episode we’ll focus on the accounting for debt securities.

Mike: And to answer your question, let’s talk about held-to-maturity securities first. These are investments that the bank has the positive intent and ability to hold until maturity and, according to ASC 320, these securities are reported on the balance sheet at amortized cost.

Chris: They’re not held at fair value?

Mike: No. That is an advantage! The bank doesn't have to worry about short term fluctuations in price...and neither do bank shareholders...because the bank plans to hold the investment until maturity! Fair value is only disclosed.

Chris: What if they decide to sell them before maturity? This is what happened to SVB, right. 

Mike: Well, if the sale is not one of the allowable exceptions outlined in ASC 320, bad things happen!

Chris: Like what? What are those bad things that would happen?

Mike: First, all the other held-to-maturity securities would need to be transferred to either the trading or available-for-sale categories, both of which are reported on the balance sheet at fair value, meaning that any unrealized losses would immediately be recognized, either in the income statement or within accumulated other comprehensive income. More on that in a moment. Second, that category is tainted, meaning that the bank cannot classify any future debt securities as held to maturity for two years.

Chris: You mentioned some sales are “permitted.” Can you expand on that?

Mike: Sure. There are specific times when an entity can sell held-to-maturity securities and not taint their portfolio. ASC 320 provides examples of sales that wouldn’t taint the portfolio. Things like evidence of a significant deterioration of the issuer’s creditworthiness.

Chris: Makes sense. It wouldn’t be fair if an issuer is really experiencing problems that the accounting rules would require them to hold and lose all their money.

Mike: Exactly. Another example would be 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.

Chris: What if, hypothetically, a bank was forced to sell such securities because there was a run on the bank?

Mike: Great question and very relevant to what happened at SVB! I actually looked into it and found an answer within the guidance. Specifically ASC 320-10-25-8 says if a regulator directs a particular institution (rather than all institutions supervised by that regulator) to sell or transfer held-to-maturity securities (for example, to increase liquid assets), those sales or transfers are not consistent with the permissible sale exception that we just discussed. That said, there is another “catch all” exception within the guidance that says only if a sale meets the following 4 conditions it would not taint the portfolio, These conditions are:

1. The event is isolated
2. The event is nonrecurring
3. The event is unusual for the reporting entity
4. The event could not have been reasonably anticipated

Chris: I would say a run on the bank would qualify!

Mike: And the FASB agrees with you. ASC 320-10-25-10 states “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.

Chris: What types of held-to-maturity securities does SVB hold?

Mike: 75% of the category, or $68.2 billion, is agency-issued residential mortgage-backed securities. Another 16% of the category, or $14.5 billion is agency-issued commercial mortgage-backed securities.

Chris: So, pretty safe stuff, given it is issued by entities like Fannie or Freddie which, as we saw during the 2008 financial crisis, is more or less backed by the U.S. government.

Mike: Exactly! The remaining 9% of the category comprises municipal and corporate bonds.

Chris: Let’s move on to debt securities classified as available for sale.

Mike: Before we do, let’s talk about debt securities classified as trading. These are securities that the bank acquires with the intent of selling it within hours or days, although the guidance does not preclude entities from using this category if they want to. Trading securities are reported at fair value, with changes in fair value immediately reported in profit or loss. SVB did not have any debt securities classified as trading, and this is typical of most banks.

Chris:  Available-for-sale securities are investments in debt securities not classified as either trading or held to maturity. Such investments are reported at fair value with changes in fair value, in other words unrealized gains or losses, recorded, net of tax, in OCI.

Mike: For those out there that don’t know, what is OCI?

Chris: OCI stands for “other comprehensive income” and is a separate component of equity. So, unlike trading securities, unrealized gains or losses on available-for-sale debt securities do not show up in the income statement, unless there is an impairment loss that is required to be reported in profit or loss.

Mike: I noted that SVB had $2.5 billion of unrealized losses in its available-for-sale portfolio that appear to still be included in OCI. Can you briefly explain the impairment rules for this category?

Chris: Sure. We measure impairment of available-for-sale securities on a security-by-security basis. If a debt security’s fair value, which is its carrying value, is less than the amortized cost, it has an unrealized loss and that security is considered impaired. However, as you noted with SVB, that unrealized loss can still reside within OCI. Only in certain circumstances is that impairment loss recycled out of OCI and recorded as an impairment loss in the income statement.

Mike: Such as?

Chris: First, if the entity intends to sell the security or it is more-likely-than-not that they will be required to to sell the security before recovery of the amortized cost basis, then the full amount of the impairment loss is immediately recognized in the income statement. If that’s not the case, then we need to determine if any of the unrealized loss relates to a credit loss. If a credit loss exists, it must be recorded in the income statement with an offset to the allowance for credit losses.

Mike: So you mean that credit losses on available-for-sale securities show up in the allowance for credit losses account, a contra-asset in the balance sheet? Doesn’t that mean that if things “get better,” that allowance will get reversed?

Chris: It certainly will and that’s one of the big changes brought about by ASC 326!

Mike: What about the portion of the unrealized loss that does not relate to credit losses?

Chris: It remains in OCI.

Mike: So, related to the $2.5 billion unrealized losses for its available-for-sale debt securities that are still sitting in OCI, SVB must have determined that:

1. It did not intend to sell the securities;
2. It was not more-likely-than-not that it would be required to sell the securities prior to recovery of the amortized cost basis; and
3. None of the unrealized losses related to credit losses.

Chris: That is correct. I am assuming most of the unrealized losses were interest-rate related, given the rising interest rate environment, as well as the fact that, I would assume, they hold investments that are of high credit quality. What types of available-for-sale securities does SVB hold?

Mike: Well, much like the held-to-maturity portfolio, it appears the debt investments in this category are relatively safe. They had $16.1 billion in U.S. Treasury securities, representing 62% of the entire category. The rest of the category was agency-issued residential- and commercial-backed securities, with the exception of $1.1 billion in foreign government debt securities.

Mike: I just realized that we didn’t talk about impairment for held-to-maturity securities. SVB had $15.2 billion of unrealized losses related to its held-to-maturity portfolio (remember, you'll have to look in the footnotes to find this).

Chris: Held-to-maturity debt securities are part of the current expected credit losses (CECL) that need to be estimated in accordance with ASC 326 and we definitely don’t have enough time for that one! We’ll have to save that topic for another episode!

Mike: Sounds like a plan. One more thing. Real quick. We do have 2 courses dealing with accounting for investments under ASC 320 and ASC 321 available on the Revolution, our online learning platform. We’ve packaged them together in a 2-course collection priced at a significant discount. I’ll put the link to this collection in the notes to the podcast. 

Chris: Well, that’s all for this episode of GAAP Chats, your source for all things accounting.  Notes and resources from today’s episode are linked in the description and as always you can find us online at GAAPDynamics.com, and @gaapdynamics across social media. It’s never too late to become a GAAPologist! Head over to our website and subscribe to our blog so that you’re the first to know what’s new with GAAP Dynamics.

About GAAP Dynamics  

We’re a DIFFERENT type of accounting training firm. We don’t think of training as a “tick the box” exercise, but rather an opportunity to empower your people to help them make the right decisions at the right time. Whether it’s U.S. GAAP training, IFRS training, or audit training, we’ve helped thousands of professionals since 2001. Our clients include some of the largest accounting firms and companies in the world. As lifelong learners, we believe training is important. As CPAs, we believe great training is vital to doing your job well and maintaining the public trust. We want to help you understand complex accounting matters and we believe you deserve the best training in the world, regardless of whether you work for a large, multinational company or a small, regional accounting firm. We passionately create high-quality training that we would want to take. This means it is accurate, relevant, engaging, visually appealing, and fun. That’s our brand promise. Want to learn more about how GAAP Dynamics can help you? Let’s talk!

Disclaimer  

This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.