Turning Income Tax Payable Into Earnings

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The New Markets Tax Credit (NMTC) Program is a two decade old federal tax credit program administered by the Community Development Financial Institutions Fund designed to monetize credits awarded by Department of the Treasury for community revitalization.

A federal tax credit is a dollar-for-dollar reduction of federal income tax payable; it is a permanent reduction of tax in the year the credit is taken. If a bank can acquire them for less than $1, it ends up converting an income tax liability into an earning. The credit creates more net income by reducing the amount in taxes owed.

The CDFI Fund has awarded 18 rounds of NMTCs, totaling $71 billion in tax credit authority. As of October 2022, $60.4 billion in NMTCs have been invested in low-income communities, creating jobs from investments in manufacturing, retail and technology projects. NMTCs are a 39% tax credit paired with a leverage loan. The Office of the Comptroller of the Currency wrote in 2013 that these credits “can help banks meet their financial goals (competitive returns on their equity investments)….[m]eet CRA requirements….[a]nd are a critical tool in helping the credit needs of low-income communities.”2

Of course, as with any equity investment there are risks; risks associated with tax credits include recapture risk, default risk, reputation risk and a lack of liquidity. But these deals are structured with full forbearance from debt that makes the probability of a redemption event unlikely. There’s also less risk at the project level compared with other tax credit programs available to corporations. And a 2017 study found a very low recapture rate.

The average return associated with the NMTC Fund, as of November 2022, outperformed seven-year US Treasurys and seven-year investment grade bonds by more than 2.43x and 1.6x, respectively in 2022 on a pre-tax basis.

Returns represent the internal rate of return of each investment categorized as held-to-maturity. The seven-year investment grade bonds for 2022 was determined based on a benchmark interest rate of the same maturity, plus the ICE BofA US Corporate Investment Grade Option-Adjusted Index. NMTC Fund returns are based on recent pricing.

Accounting Options
Typically, banks use two options for GAAP accounting using ASC 740 provisions:

  • Flow Through Method: The NMTC amount reduces the income tax expense (below the line). Impairment of the investment balance is categorized as an other expense, impacting pretax income (above the line).
  • Deferral Method: The tax credit is recognized as a contra asset (deferred income liability) and amortized into income over the productive life of the investment.

The Financial Accounting Standards Board’s Emerging Issues Task Force is evaluating whether it should expand the proportional amortization method to investments in tax credits beyond LIHTC investments, including investments in NMTCs (below the line treatment), a change many expect to be adopted as early as the first quarter of 2023.

Momeni & Sons Case Study
In 2022, Momeni & Sons, a manufacturer and importer of area rugs, wall-to-wall carpeting and home décor, wanted to establish a 302,600 square foot warehouse and distribution facility in Adairsville, Georgia, to accommodate growing online sales and bring more economic opportunity to the Adairsville community.

Given the magnitude of the project’s size and the rising cost of construction materials, the company needed about  $18.7 million to finance the project; its lender also determined that the project could be supported by the NMTC program. With $14 million in NMTC allocation, Wayne, New Jersey-based Valley National Bancorp was able to provide the tax credit leverage loan and the equity in the deal.

Momeni’s new facility created 100 construction jobs and 98 full-time quality jobs at its completion in August 2022, boosting the local economy of Adairsville. The project provided skills training in conjunction with a local workforce development provider, creating high-quality training and instruction to the area; at least 65% of Momeni’s Adairsville labor force will be minority residents.

New Markets Tax Credits provide a lesser-known opportunity for banks to convert tax liability to earnings, while potentially providing Community Reinvestment Act benefits, deposits and loans. There are syndication options available, which eliminate the need for smaller banks to create an independent infrastructure around the NMTCs.

This overview is for informational purposes only and is intended for recipients having sufficient knowledge and experience to make an independent evaluation of the risks and merits of any financing. The New Markets Tax Credit program is extremely complex. Consult your legal counsel, tax counsel and accountant. This information and opinions included in this overview do not, and are not intended to, constitute legal or tax advice. Dudley Ventures makes no representations or warranties of any kind, express or implied, as to the accuracy or completeness of the information or opinions. © 2022 Dudley Ventures, LLC, a Delaware limited liability company. All rights reserved.

CECL: Navigating Regulatory Expectations

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CECL-11-24-17.pngThe issuance of the new current expected credit loss (CECL) standard in June 2016 represents a substantial accounting change, and many boards are trying to determine how their institutions will comply with the new standard. In Frequently Asked Questions on the New Accounting Standard on Financial Instruments—Credit Losses, the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corp. and National Credit Union Administration (collectively, the Agencies) state that they expect supervised institutions to make good-faith efforts to implement the new accounting standard in a sound and reasonable manner. Given the likely expectation that CECL will increase allowance levels and lower capital, regulatory expectations will be heightened.

Significant changes in the Allowance for Loan and Lease Losses (ALLL) are not unique. Institutions can look back just 20 years and recognize regulatory guidance that looked at percentages of classified loans as a measure of ALLL adequacy irrespective of the methodology chosen under generally accepted accounting principles (GAAP). Refinements in 2001 and 2006 furnished guidelines of acceptable ALLL methodologies to provide consistency for GAAP and regulatory purposes. Although mathematically accurate, as seen with the recent financial crisis and long recovery period, it’s becoming increasingly difficult to measure and react to changing economic conditions.

A noted benefit to the new standard is the flexibility in determining expected losses. The Agencies recognize this flexibility, but institutions should use judgment in developing estimation methods. Any method chosen should be well-documented, applied consistently over time and provide a good-faith estimate to the collectability of financial assets. Further, the Agencies have commented that smaller and less complex institutions will be able to adjust their existing allowance methods to meet the new accounting standard’s requirements without the use of costly, complex models.

So how do financial institutions focus on getting this methodology change right, and what should the board be focused on?

The board of directors plays a pivotal role in the effective governance of its institution by overseeing management and providing organizational leadership through core corporate values. This helps keep the institution operating in a safe and sound manner, and comply with applicable laws and regulations. Directors are not expected to be actively involved in day-to-day operations, but should provide clear guidance and monitor risk exposure through established policies, procedures and practices. The board, typically through an established audit committee, has broad oversight to monitor the financial reporting process and oversee the financial institution’s establishment of accounting policies and practices. In anticipation of implementing CECL, the board should consider reviewing the significant qualitative aspects of the bank’s accounting practices, including accounting estimates, financial reporting judgments and financial statement disclosures.

Existing regulatory guidance provides a roadmap of expectations regarding the ALLL methodology, and expectations will likely remain unchanged with the new CECL standard. The guidance states that for an institution’s ALLL methodology to be effective, the institution’s written policies and procedures should address:

  • The roles and responsibilities of bank personnel involved in the ALLL process,
  • The institution’s accounting policies affecting the ALLL,
  • A narrative of the institution’s methodology, and
  • Documentation of the internal controls used in the ALLL process.

Some institutions are considering the use of third-party vendors for CECL implementation, and in this case, boards should ensure their institutions have appropriate processes in place for selecting vendor models. As part of this process, institutions should require that the vendors provide developmental evidence explaining the product components, its design and proof that the product works as expected, with an understanding of the model’s limitations. Whether the model is developed in-house or by a vendor, all model components, including input, processing and reporting, should be subject to an independent validation that’s consistent with current regulatory guidance. Also, depending on the complexity of the method chosen, certain models likely will be within the scope of the Agencies’ model risk management guidelines, and institutions will need to consider ways to effectively challenge those new models.

Boards should become familiar with the new standard and work with management to understand the plan to implement it, based on the institution’s size and complexity prior to the applicable effective date. Boards should also make sure they’re regularly updated on the status of implementation efforts. It’s expected that examiners will begin to inquire about the status of institutions’ implementation efforts and as the effective date nears, examiners will want to know the new standard’s effect on the bank’s capital levels.

Implementing CECL will be a significant challenge for institutions that aren’t diligent and timely in creating and executing a plan with input from many key stakeholders—including the board. Active participation on the part of directors will be critical in its success.

Does Your Bank Have the Stress Testing Data You Need?

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stress-testing-8-26-16.pngThe next several years will increase the need for better data management at banks. Banks that have experienced the Dodd-Frank Act’s required stress tests (DFAST) already have encountered that need. With the Basel III international accord phasing in and the new current expected credit loss impairment standard (CECL) eventually taking effect, all U.S. financial institutions are facing ever more demanding regulatory requirements driving the need for enhanced data and analytics capabilities.

Credit data is becoming increasingly integral to stress tests, as well as capital planning and management and credit loss forecasts. To meet regulatory expectations in these areas, though, some banks need to improve the quality of their data and the control they have over it. Effective data management can bring valuable support and efficiencies to a range of compliance activities.

Expanding Data Requirements
DFAST, which is required of banks above $10 billion in assets, is highly dependent on data quality. The DFAST process—including scenarios, analytics, and reporting—requires banks to maintain a vast array of reliable and detailed portfolio data, including data related to assets and liabilities; to customers, creditors and counterparties; to collateral; and to customer defaults.

Under Basel III, banks will need to gather even more data. The requirements call for consistent data sourcing and reconciliation, liquidity management and the capture of data for historical purposes, among other things.

The Financial Accounting Standards Board’s new CECL model for GAAP reporting applies to all banks and will bring implications for data management. Banks and financial services companies will need borrower and economic data, exposure level data, historical balances, risk ratings and data on charge-offs and recoveries. Failure to capture quality data in these and other areas could result in tougher examinations, reliance on peer or industry data, questions about safety and soundness and drops in capital and profits.

Data Management Challenges
Small banks generally have a handful of credit data sources, while large banks can have 15 or more—and the number of sources is expected to grow in coming years as new products are released. In addition, the data often is stored in different formats and might not be subject to any governance or control. It’s no wonder that banks can find it difficult to get a handle on their data, let alone produce a “single source of truth” that can withstand examiner scrutiny.

One solution to this dilemma is a credit data warehouse. A data warehouse can provide a vehicle for controlling and governing an immense amount of data. It allows a bank to easily show an examiner the data that was used for its models, the data sources and how the data reconciles with the bank’s financial statements.

Banks might encounter some obstacles on their way to effective warehousing, though, including the sheer volume of data to be stored. Quality assurance is another common issue. For example, information might be missing or not in a standardized format. Data availability also can pose problems. A bank might have the required information but not in an accessible format.

Best Practices
Overcoming these problems comes down to data governance—how a bank manages its data over time to establish and maintain the data’s trustworthiness. Data management without active governance that is targeted toward achieving a single source of truth isn’t sustainable.

In the case of DFAST, it’s important to resist the temptation to take a short-term perspective that considers only the data required for stress testing. Banks that take a more global view, bearing in mind that the data is used throughout the organization, will fare much better. Such banks build a framework that can handle the new data requirements (including those related to historical data) that will surely continue to come in the future.

Banks also should remember that data management is not a one-off task. A bank might have clean data today, but that data will degrade over time if not managed on an ongoing basis.

Finally, banks should not overlook the human factor. Success isn’t brought about by a database but by the people who are stewards for the data and the processes put in place to audit, balance, and control the data. The people and processes will, of course, be enabled with technology, but the people and processes will make or break a data management program.

Time to Take Control
Effective data management is an essential component of any stress testing endeavor, but data management also has implications that extend to CECL and Basel III compliance and likely will aid banks in coping with many forthcoming regulations and requirements. Banks that don’t yet have control of their data should take steps now to establish the governance, framework and people and processes necessary to ensure the completeness, accuracy, availability and auditability of a single source of truth for both the short- and long-term.

FASB’s New Standards for Financial Instruments: What Banks Need to Know

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FASB-2-15-16.pngAt 232 pages, Accounting Standards Update (ASU) No. 2016-01, issued in January of 2016, might be intimidating, but we will boil down the essentials you need to know as a bank accountant, chief financial officer, or member of an audit committee. In 2010, the Financial Accounting Standards Board (FASB) issued a massive proposal with many significant changes including marking the majority of a bank’s balance sheet (securities, loans and deposits) to fair value. The FASB has come a long way since then and completes part one of its financial instruments project with the issuance of this standard. When boiled down, the standard contains eight or nine significant changes of interest to banks. Not every bank will be affected by all of the changes, and whether you view these changes as positive or negative depends upon whether you are a preparer or user.

Two of the changes—both of which the banking industry views as favorable—may be adopted early for financial statements not yet issued:

  • Liabilities using the fair value option: Under current generally accepted accounting principles (GAAP), the change in fair value resulting from instrument-specific credit risk is presented in earnings, which has an interesting result. As a bank’s own credit worthiness declines, income is recorded because the value of the liability declines, usually the bank’s debt. Many found that to be an odd outcome—and the FASB agreed. This ASU corrects that and those changes now will be recorded in other comprehensive income (OCI) instead of earnings, and consistent with regulatory capital treatment.
  • Disclosures of fair value of financial instruments: In an effort to provide relief, the FASB is dropping this requirement, which was born in Financial Accounting Standards (FAS) No. 107, for non-public business entities (non-PBEs). Beware, though: The definition of PBE is very broad and extends far beyond those who file with the SEC. Many banks have been surprised to learn they are considered to be PBEs.

The most significant change is that PBEs will have to calculate fair values using the exit price notion, obtaining a fair value using what a market participant would use. This is a big deal because under current GAAP, there is a provision that permits banks to calculate these fair values using a discounted cash flow approach known as entrance pricing. For example, the fair value of loans commonly is computed by discounting the cash flows using the current rates at which similar loans would be made to borrowers with mirroring credit ratings and remaining maturities. Requiring exit pricing could prove challenging, particularly for loans. A small but positive change for PBEs is the elimination of the requirement to disclose the methods and significant assumptions used.

The next big area of change is for equity investments, with general exceptions for those using the equity method or those that are consolidated. The unpopular change for banks is that, going forward, changes in fair value will run through earnings. Under current GAAP, equity investments can be classified as available for sale (AFS) with fair values changes running through OCI, or trading with fair value changes running through earnings. This change eliminates the AFS option.

There is good news, however, for equity investments without readily determinable fair values. Banks will have the option to measure these at cost minus impairment, if any, plus or minus changes resulting from qualifying observable price changes. This means investments can be written up with proper observable transactions. The FASB also simplified the impairment assessment by using a qualitative assessment.

Two more changes:

  • Deferred tax assets (DTAs) on AFS securities: Currently there is diversity in practice on evaluating such DTAs separately (given management has control because the securities can be sold) or in combination with other DTAs. The FASB chose the latter.
  • Measurement category: Financial assets and liabilities must be presented by measurement category (such as fair value or amortized cost) and form of financial asset (securities, loans or receivables) on the balance sheet or in the footnotes.

When Is This Effective?

For PBEs, the changes take effect for fiscal years beginning after Dec. 15, 2017, including interim periods within (which means first quarter of 2018 for calendar year-end reporting companies).

For non-PBEs, the changes take effect for fiscal years beginning after Dec. 15, 2018, and interim periods beginning after Dec. 15, 2019 (which means Dec. 31, 2019, for calendar year-ends).

The FASB plans to issue part two of its financial instruments project, a final standard on credit losses, in the first part of 2016 and part three, a proposal on hedging, in the second quarter of 2016.