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Good morning. US stock markets rallied well yesterday and climbed higher, in stops and starts, for two weeks. The S&P 500 is back where it was on March 8, the day Silicon Valley Bank announced its doomed capital raise. Everything is clear, then? We are thinking about it. In the meantime, some thoughts below on whether poor accounting rules contributed to the SVB mess. Email us: robert.armstrong and ethan.wu.

Can we blame the accounting?

In yesterday’s Wall Street Journal, Jonathan Weil paints an unflattering picture of how six major banks accounted for their large holdings of securities. The article serves to crystallize the debate over whether securities accounting – specifically the treatments of “held-to-maturity” (HTM) and “available-for-sale” (AFS) securities – is wrong. and contributed to the failure of Silicon Valley Bank and emphasizes other banks, primarily the First Republic.

If a bank classifies a security as held to maturity, then it is held at cost. Changes in the market value of the security – although disclosed in the footnotes to the financial statements – are not passed on to the income statement and are not recorded on the balance sheet, so they do not influence the levels capital. If the same security is marked as available for sale, changes in its value, although still excluded from the income statement, are reflected in its balance sheet, and therefore in the bank’s equity.

Weil’s article points out that the six banks (JPMorgan Chase, Wells Fargo, Truist, US Bancorp, PNC and Charles Schwab) together transferred half a trillion dollars worth of securities from AFS to HTM last year. The rise in interest rates means that the fair value of securities was falling; keeping them in AFS would have meant a blow to capital. If the banks marked their HTM securities on the market, it would have meant an 18% drop in their equity.

The unspoken implication of the article is that this “switcheroo”, while not breaking any rules, is nonetheless dodgy. The article quotes Sandy Peters, Financial Reporting Policy Officer at the CFA Institute:

It is an artificial accounting construct and not an economic measure of the value of assets. . . The value of a bond does not change based on how management decides to classify it. It’s worth what it’s worth.

Although Weil focuses on specific banks, it should be noted that the American banking system as a whole is very similar to these banks. Here is a chart of all banks’ unrealized losses on HTM securities as a percentage of total system equity:

Some people say the system would work better if all titles got the AFS treatment. They argue that forcing banks (and their investors) to recognize losses on securities would require more careful management. Coincidentally, two such people, Charles Calomiris and Phil Gramm, featured the case in the WSJ’s op-ed pages on Tuesday, saying acknowledging the losses would force banks to reduce leverage and hold more cash.

There’s clearly something odd about banks devoting so much of their balance sheets to securities and then effectively declaring that the market value of those portfolios doesn’t matter to their financial strength. It is also odd that a bank actually promises never to sell its securities (or risk a capital hit) when historically the reason banks hold securities is to provide liquidity.

Indeed it is downright bizarre, as Jennifer Hughes of the FT pointed out to me, that the same government guaranteed securities can be counted as held to maturity at the same time that they are considered liquid assets high quality for the purpose of calculating liquidity ratios of banks.

So what’s the argument for allowing HTM accounting for banking securities? On the one hand, one has to ask whether it makes sense for banks to adjust their capital ratios upwards when interest rates fall. AFS accounting would make most banks automatically better capitalized whenever rates fall, even if the reason for that rate drop was, say, a major recession.

This is just one example of a larger problem, which is that AFS accounting would make the asset side of the balance sheet much more volatile than the liability side. Chris Marinac, director of research at Janney, told me:

The problem from the start [has been] that both sides of the balance sheet should be marked. If interest rates rise and hurt the value of banks’ loans and securities, the opposite side must be increased for deposits and liabilities. A no-fee demand deposit and other contractual deposits (CDs/term deposits) are more valuable as interest rates rise, at least in theory.

[But] of course, banks are leveraged 12 to 1, so the inherent value of deposits is highly questioned after a “bank run” [such as the one we saw] in a handful of institutions in March 2023. . . When we impose accounting marks on leveraged financial institutions, it creates volatility and therefore new guardrails and safety nets need to be installed

Finally, it must be recognized that imposing AFS accounting on bank securities would require banks, as a group, to either hold more capital or hold less Treasury bills and mortgage-backed securities. agency, or both. I won’t get into the debate about bank capitalization levels here, except to note that there is a trade-off between the safety of higher capital and the risk that more loans will be forced out of the banking sector and to go to less regulated places. Regarding securities, did we not conclude after 2008 that it was good for banks to hold a set of assets without credit risk?

I have very mixed feelings about this debate, but one source, a seasoned banker, suggested there might be a middle way. Only very large securities portfolios are a problem: the SVB and a few other banks have used government-guaranteed bonds to make all-in rate bets. A regulatory option would be to say that if a portfolio of securities exceeds a certain size relative to a bank’s capital, it must be marked to market or sold.

What would have really helped, of course, is if SVB and its regulator had simply stress tested its balance sheet against the rate hike, had come to the conclusion that it was a ticking time bomb and had done something about it. How it didn’t happen remains a mystery, at least to me. Not all bank failures call for a rule change. Firing a bunch of banking regulators could do the trick almost as well.

A good read

Caitlin Clark is fine.

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