Fundamentals of Financial Institutions

Jing Li

Topic 5: Fair Value Measurements of Financial Instruments

Agenda

 Introductory comments and concepts

 Illustrative example of fair value accounting

 Varieties of Fair Value Reporting by Banks

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 What is Fair Value?

 Ideally, Fair value equals the NPV of expected future cash flows using current
information about cash flows and current market interest rates
 subtlety: entry value vs. exit value vs. value in use

 In FAS 157, FASB chose EXIT VALUE—the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date
 in principal market if it exists and most advantageous market otherwise
 not adjusted for most transactions costs (e.g., bid-ask spread); adjusted
for transportation costs
 in-use (in conjunction with complementary items) versus in-exchange
(standalone basis) valuation premises
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Fair Value Hierarchy

 FAS 157 provides a hierarchy of fair value measurement inputs

 level 1: quoted prices for identical items traded in active markets

 level 2: other observable market data such as quoted prices for similar
items or in inactive markets, yield curves and other price curves, inputs
derived primarily from market data by correlation or other means

 level 3: unobservable firm-supplied inputs that reflect the reporting

entity’s own assumptions about the assumptions that market
participants would use in pricing the asset/liability

 Debate over Fair Value Accounting 4

 Amortized Cost vs. Fair Value Accounting

Summary: Balance Sheet Differences

Amortized Costs Method Full Fair Value Method

 On initial acquisition, assets and  On initial acquisition, assets and

liabilities are recognized at original liabilities are recognized at original cost
cost (= fair value) (= fair value)

 As time lapses, assets and liabilities  As new information arrives (interest rate
are adjusted to amortized cost (not or collectability changes), assets and
mark-to-market, ignoring new liabilities are adjusted to fair value (or
information) mark-to-market)

 When sold/payoff, amortized costs is  When sold/payoff, fair value is removed

removed 6
 Summary: Income Statement Differences
Amortized Cost Methods (Full) Fair Value Method
 Book interest income/expenses equal  Book interest income/expenses equal to
to the amortized cost times the the weighted-average fair value times the
effective interest rate at inception weighted-average market interest rate
(ignore current market interest rate) during the period

 Unrealized gains and losses are NOT  Unrealized gains and losses are
recognized recognized due to new information

 Realized gains or losses are  Realized gains or losses are recognized

recognized due to asset sale or liability due to asset sale or liability paid-off
paid-off
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Amortized Cost T Account for Financial Asset (Including

Interest Receivable)
Financial Asset (B/S) Cash (B/S)
+Interest received
Beginning amortized cost
+Principal received
+Amortized cost interest revenue -Interest received
-Principal received Interest Revenue (I/S)
=Ending amortized cost +Amortized cost
interest revenue

- Amortized cost of interest revenue for financial assets equals the beginning amortized cost
(or weighted-average amortized cost during the period if new loans/assets are
initiated/acquired) times the effective interest rate at the date of inception or acquisition

- The ending balance of amortized cost of financial assets equals net present value of the
remaining promised fixed principal and interest cash flows discounted using the effective
interest rate (level yield) determined at inception
 Amortized Cost T Account for Financial Liability
(Including Interest Payable)
Cash (B/S)
Financial Liability
Beginning amortized cost - Interest paid
- Interest paid + Amortized cost interest expense - Principal paid
- Principal paid
Interest Expense (I/S)
- Buyback at amortized cost
= Ending amortized cost +Amortized cost
interest expense

- Amortized cost of interest expense for financial liabilities equals the beginning amortized cost
of liability (or weighted-average amortized cost during the period if new loans/assets are
initiated/acquired) times the effective interest rate at the date of inception
- The ending balance of amortized cost of financial liabilities equals net present value of the
remaining promised fixed principal and interest cash flows discounted using the effective
interest rate (level yield) determined at inception

Example 1: Amortized Cost Accounting for a Fixed-Rate Loan

At the beginning of year 1, a firm acquires a single credit-riskless fixed-rate financial

asset (a loan) that pays $10 at end of each of years 1-3. Given a market interest rate
of 10% at that time, the value of the loan at initiation is
$24.87=$10/1.1+ $10/1.12+$10/1.13

The firm holds the loan for the 3 years. The loan amortization schedule is

Year 1 2 3
Beginning balance $24.87 $17.36 $9.09
+Interest revenue $2.49 $1.74 $0.91
-Cash receipt ($10.00) ($10.00) ($10.00)
=Ending balance $17.36 $9.09 $0.00
Example 2: Amortized Cost Accounting for a Fixed-Rate bond

At the beginning of year 1, a firm acquires a single credit-riskless zero coupon bond
that pays $30 at the end of year 3. Given a market interest rate of 10% at that time, the
value of bond at initiation is $22.54=$30/1.13

The firm holds the bond for the 3 years. The bond amortization schedule is

Year 1 2 3
Beginning balance $22.54 $24.79 $27.27
+Interest revenue $2.25 $2.48 $2.73
-Cash receipt ($30.00)
=Ending balance $24.79 $27.27 $0.00

Full Fair Value T Account for Financial Asset (Liabilities)

Financial Asset
Beginning balance
+ Fair value interest revenue - Interest received
- Principal received
+ Total fair value gains/losses

= Ending balance Financial Liability

Beginning balance
- Interest paid + Fair value interest expense
- Principal paid
+ Total fair value gain/losses
= Ending balance
Example 1: Full Fair Value Accounting
 Same as fixed-rate asset in numerical example 1, but change in the
relevant market rate to 12% at the end of year 1 is reflected in fair value
 End of year 1 balance: $16.90=10/1.12+10/1.122
 The interest rate change yields a loss of $0.46 =$17.36 - $16.90
Year 1 2 3
Beginning balance $24.87 $16.90 $8.93
+ interest revenue $2.49 $2.03 $1.07
- cash receipt ($10.00) ($10.00) ($10.00)
+ gain ($0.46) $0.00 $0.00
= Ending balance $16.90 $8.93 $0.00
Income (interest revenue plus gain) $2.04 $2.03 $1.07

Example 2: Full Fair Value Accounting for zero coupon bond

 Same as fixed-rate asset in example 2, but change in the relevant market

rate to 12% at the end of year 1 is reflected in fair value
 End of year 1 bond’s fair value: $23.91=30/1.122
 The interest rate change yields a loss of $0.88 =$24.79 - $23.91
Year 1 2 3
Beginning balance $22.54 $23.91 $26.79
+ interest revenue $2.25 $2.87 $3.21
- cash receipt ($30.00)
+ gain (-loss) ($0.88) $0.00 $0.00
= Ending balance $23.91 $26.79 $0.00
Income (interest revenue plus gain) $1.38 $2.87 $3.21
 Attributes of “Full” (Ideal) Fair Value Accounting

 Assets and liabilities are recognized at fair value on the balance sheet
 Gains and losses are recognized on the income statement/OCI as they occur
 Interest revenue on assets or interest expense on liabilities equals the weighted-
average fair value times the weighted-average relevant market interest rate during
the period
 Separate classification of interest versus gains and losses on the income
statement
 Interest is permanent, gains and losses are transitory except that firm should
earn normal rate of return on increment to fair value
 In practice, interest usually is combined with gains and losses for trading
positions

Questions

 Q: How do fair value and amortized cost accounting (for both the
asset and debt) differ in terms of how they

 recognize income over time?

 classify income?

 total income recognized?

AC and FV difference

Fixed Rate Loans

Year 1 2 3 Total (sum 3 years)
Amortized Cost
+Interest revenue $2.49 $1.74 $0.91 $5.13

Fair value
+ interest revenue $2.49 $2.03 $1.07 $5.59
-Loss ($0.46) $0.00 $0.00 ($0.46)
Net Income $2.04 $2.03 $1.07 $5.13

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AC and FV difference

Fixed Rate Loans

Year 1 2 3 Total
Amortized Cost
+Interest revenue $2.25 $2.48 $2.73 $7.46

Fair value
+ interest revenue $2.25 $2.87 $3.21 $8.34
-Loss ($0.88) $0.00 $0.00 ($0.88)
Net Income $1.38 $2.87 $3.21 $7.46

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 How about floating rate?

 Amortized cost and fair value accounting have similar balance

sheet and income statement presentations.
 Net present value based on floating rate (if close to the
market rate) remains unchanged throughout
 Interest revenue/expense incurred on assets/liabilities reflect
the market rate.

 But if floating rate is not perfectly market rate-> FV and AC may

still be different

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Example 3: Amortized Cost/Fair Value Accounting for a Floating-Rate

Bond
At the beginning of year 1, a firm acquires a single credit-riskless with a floating-rate financial
asset (a bond) for $30. The bond’s floating payments are reset each year based on the
current floating rate.

The floating rate, rs, for s from 1 to 3, is determined at the beginning of year s and turns out
to be r1=10%, r2=12%, r3=11%

Year 1 2 3
Beginning balance $30 $30 $30
+Interest revenue $3 $3.6 $3.3
-Cash ($3) ($3.6) ($33.3)
=Ending balance $30 $30 $0.00
 US GAAP “Mixed Attribute” model
 The current “mixed attribute” accounting model requires fair value accounting only for
a subset of banks’ financial instruments
 some investment securities under FAS 115
 all derivatives and hedged items in designated, effective fair value hedges under
FAS 133
 cash flow hedge derivatives on balance sheet only
 Certain financial guarantees (as a contingent liability) at initiation under FIN 45

 FAS 159 allows reporting firms to self-select (fair value option) which items to apply fair
value accounting (and mitigate comparability problems through additional disclosure)
 For certain financial instruments (loans, deposits, long-term debt)
 Balance sheet values (or Carrying value) are not fair-value basis
 But Fair value are disclosed in the footnotes to financial statements

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Fair Value Accounting In Practice

 Explicitly under certain GAAP standards (e.g., FAS 115) and in practice
otherwise, interest revenue on assets and interest expense on
liabilities are measured on an amortized cost basis even for positions
measured at fair value on the balance sheet

 This inconsistent measurement of interest revenue and expense and

carrying values yields apparent reversal of fair value gains and losses
 Errors in interest revenue or expense must be offset by errors in
gains and losses
 Bottom line net income is measured properly
Example 1: Fair Value Accounting In Practice With Amortized Cost Interest

Year 1 2 3
Beginning balance $24.87 $16.90 $8.93
+interest revenue (amortized $2.49 $1.74 $0.91
cost)
-cash receipt ($10.00) ($10.00) ($10.00)
+ gain ($0.46) $0.29 $0.16
=Ending balance $16.90 $8.93 $0.00
Income (same as full fair value
accounting) $2.04 $2.03 $1.07

The unrealized loss in year 1 appears to reverse fully in years 2 and 3

Fair Value Hierarchy

 FAS 157 provides a hierarchy of fair value measurement inputs

 level 1: quoted prices for identical items traded in active markets

 level 2: other observable market data such as quoted prices for similar
items or in inactive markets, yield curves and other price curves, inputs
derived primarily from market data by correlation or other means

 level 3: unobservable firm-supplied inputs that reflect the reporting

entity’s own assumptions about the assumptions that market
participants would use in pricing the asset/liability

 Debate over Fair Value Accounting 24

 BOA (Note 1: fair value accounting policy)

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BOA (Note 1: fair value accounting policy)

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 Amortized Cost vs. Fair Value on Balance Sheet
Assets and Liabilities Measurement

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A Simple Example with both asset and liability

 Assume a bank has the following asset and liability
 At the beginning of year 1, a firm acquires a single credit-riskless
zero coupon bond that pays $30 at the end of year 3. Given a market
interest rate of 10% at that time, the value of bond at initiation is
$22.54=$30/1.13
 finances the purchase of bond with one-year deposit with same initial
value at 6% interest rate (i.e., borrow $22.54 by promising to pay
$23.89 at the end of year 1)
 The bank rolls over the principal and accrued interest on debt at end of
years 1 and 2 (what is the rate to roll over the debt?)
 Suppose the market interest rate on both the asset and debt changes
instantaneously by 2% at the beginning of year 1 (date 0) and stays at
that level through year 3
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Liability
 Debt needs to be rolled over each year
Date-0 Date-1 Date-2 Date-3

Date-0- cash needed 22.54

Date-0- interest rate 6%
Date-1 Rollover value needed 23.89
Date-1 interest rate 8%
Date-2 Rollover value needed 25.80
Date-2 interest rate 8%
Date-3 Final payment needed
(interest+principal) 27.87

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Liability under Amortized cost and fair value

Amortized cost
Date 0 1 2 3 Total
Liabilities 22.54 23.89 25.80
+Interest Expense 1.35 1.91 2.06 5.33

Fair Value
Liabilities 22.54 23.89 25.80
+Interest Expense 1.35 1.91 2.06 5.33

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Balance Sheet and Income Statement Over 3 years

Financial Reporting under AC Year 1 Year 2 Year 3 Total

Interest Revenue 2.25 2.48 2.73
Interest Expense 1.35 1.91 2.06
Net Interest Income under AC 0.90 0.57 0.66 2.13
Net Income 0.90 0.57 0.66 2.13
Financial Reporting Under FV
Interest Revenue 2.25 2.87 3.21
Interest Expense 1.35 1.91 2.06
Net Interest Income under FV 0.90 0.96 1.15 3.01
Net FV Unrealized Gain (0.88) 0.00 0.00 (0.88)
Net Income 0.02 0.96 1.15 2.13
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Fair Value Accounting for Banks

 Done fully and properly, fair value accounting captures banks’

matched exposures
 as information and market interest rates change, banks
experience offsetting gains and losses if exposures are matched
but not otherwise
 see income volatility in the period it occurs

 subsequently, banks earn income based on current market prices

 see true spreads

 prevents “gains trading”

 Amortized cost accounting doesn’t capture any of the above

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 Analysis Tool: Recasting income statement
 Various fair value disclosures essentially provide an incomplete fair
value balance sheet and should be used to recast the income statement
to fair value
 requires estimating the unrecognized gains and losses each period on
financial instruments recognized at amortized cost on the income
statement
 two main purposes

 provide better measure of income, or, less ambitiously, assess the

limitations of amortized cost net income
 assess IRR from past correlation of interest rate movements with
gains and losses
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Recasting the Income Statement

 For financial assets recognized at amortized cost, the

unrecognized (i.e., unrealized) pretax gain during the period is
(FVend-ACend)-(FVbeg-ACbeg)
 FV denotes fair value, AC denotes amortized cost
 For financial liabilities recognized at amortized cost, the
unrecognized (i.e., unrealized) pretax gain during the period is
-(FVend-ACend)+(FVbeg-ACbeg)
 Note change in sign from assets
 Various ways to make tax adjustments
 Last Example
Year 1 Year 2 Year 3

FV Asset 22.54 23.92 26.79

AC Asset 22.54 24.79 27.27

Reconciliation (asset only)

FV_End — AC_End (1) (0.88) (0.49) -
FV_Beg — AC_Beg (2) - (0.88) (0.49)
Adjustment (1)—(2) (0.88) 0.39 0.49
Net Income Under AC 0.90 0.57 0.66
Net Income Under FV 0.02 0.96 1.15
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Constructing (Partial) FV balance-sheet

 “Approximate” Group
 Carrying value approximate fair value

 Example: cash and cash equivalents

 “Fair Value Recognition” Group

 Carrying value equal to fair value

 Example: trading or AFS assets

 “Fair Value Disclosed” Group

 Carrying value equal to cost but fair value disclosed (fully or partially)

 Example: fair value of held-to-maturity securities and loans

 “Non-Disclosure” Group
 Carrying value equal to cost but fair value NOT disclosed

 Example: leases, goodwill, and other non-financial instruments

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BOA fair value of debt securities

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BOA Fair Value Recasting Income 2021: FV disclosure for some items
 Fair value and amortization cost difference

Comprehensive Income Statement

 Comprehensive income equals Net income plus Other comprehensive income

 In the same fashion as Net income is closed out to Retained earnings at the ends of accounting
periods, Other comprehensive income is closed out to Accumulated other comprehensive income
at period ends
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Recasting Comprehensive Income

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Recasting the Income Statement (2)

 Use bank’s disclosure to recast income

 Fair value changes during the period may be due to change in
model, change in implementation of the model, or economic events
 Some financial assets (e.g., AFS securities and derivatives used for
cash flow hedging) are recognized at fair value on balance sheet
but some or all unrealized gains and losses are recorded in other
comprehensive income, not net income, each period
 Tax: for these items, the simplest way to determine the unrealized
pretax gain necessary to adjust the income statement is as after-tax
OCI/(1-tax rate)

Varieties of Fair Value Reporting by Banks:

BOA Example

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Summary of various FV Reporting by Banks

 Financial Statements
 Balance Sheet (B/S)

 Statement of Comprehensive Income (SCI)

 Footnote Disclosures related to FV (see appendix)

 Accounting policy on Fair Value (BOA note #1)

 FAS 133 derivatives and hedging disclosure (BOA note #3)

 FAS 115 securities investment disclosure (BOA note #4)

 FAS 157 Fair Value measurement (BOA note #22)

 FAS 159 Fair Value Option (BOA note #20)

 FAS 107 financial instrument disclosure (BOA note #22)

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FAS 107 and 156: Financial Instruments

 FAS 107 requires the fair values of most financial instruments to be

disclosed for the current and prior year
 exceptions: equity interests in affiliates, firm’s own equity, MSRs, core
deposit intangibles, most insurance contracts, lease contracts

 FAS 156 requires fair value of MSRs (see securitization topic later).

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FAS 133: Derivatives

 Accounting for derivatives and hedging is governed by FAS 133 (1998)

 two follow-on standards: FAS 138 (2000) and FAS 149 (2003)

 There is also voluminous implementation guidance in Derivatives

Implementation Group (DIG) issues

 Defines derivatives for accounting purposes

 Requires that all derivatives be fair valued gross of hedged items on the
balance sheet and on income statement

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