In the December 2012 issue of ALM Insights, I wrote an article titled Basel III’s AFS Provision. At the time of the article, the provision detailing the effects of Accumulated Other Comprehensive Income (AOCI) on regulatory capital had been delayed due to a “wide range of views”, and the final outcome was still very much up in the air. Few in the banking industry thought that forcing banks of all sizes to account for AOCI in regulatory capital was the best option, but proposals for changes were wide ranging.

 

The final rule is out, and it includes a one-time option for banks to choose to either include or exclude AOCI from regulatory capital. The final ruling came through more than a year ago, but banks are required to make the decision on whether to opt in when they submit their call report for the fourth quarter of 2014, so I thought this would be an appropriate time to consider the implications one last time.

 

I think it’s pretty safe to assume that opting-out is just about everyone’s plan. While opting out will keep the price volatility of the securities portfolio out of the calculation of regulatory capital, there should be no expectation that regulators are finished criticizing interest rate risk. Banks should still be prepared to justify projected performance of their bond portfolios in +300 and +400 basis point interest rate scenarios.

 

For some banks, reclassifying the most volatile parts of the securities portfolio to held-to-maturity (HTM) can help manage that risk. We have highlighted the pros and cons of that strategy before (see the March 2014 issue of ALM Insights), but while market conditions have certainly changed a lot this year the dynamics of the decision whether or not to reclassify are the same.

 

In most cases doing so has gotten more attractive. Banks that held off on reclassifying this time last year because they were hesitant to lock in prices on bonds that were underwater, should revisit those parts of their portfolio before the end of the year. The case for hedging the risk is still valid and the market conditions have only improved.

 

If the effect of reclassifying the most volatile portion of the securities portfolio to HTM hurts the bank ability to rely on the portfolio as a source of liquidity then the current market may represent a good chance to reposition to a less risky part of the curve. Longer term yields have fallen almost 100 basis points since this time last year, while short-term yields have risen steadily in 2014. If the yield curve continues to flatten interest rate risk will become less and less attractive. But if the risk is determined to no longer be appropriate, take this as an opportunity to consider buying shorter term bonds at the highest yields since 2011.

 

In our opinion, the case for opting in and including AOCI in the calculation for regulatory capital is short sighted. For the cases where AOCI is meaningfully positive, the benefit of higher regulatory capital in the short-term is outweighed by the volatility and risk and that is added. HTM may be a good solution for banks with excess liquidity and a priority for higher interest income from the portfolio, but there are also cases where a repositioning is more appropriate. Given the permanent nature of the decisions, the long-term overall strategy of the bank should be considered.