Silicon Valley Bank disclosed that it had $1.8 billion in paper losses on some bonds due at the end of 2022.
And yet the lender did not reduce a key measure of capital strength that is monitored by regulators. Those losses came into existence for the bank after it was forced to sell these assets, triggering a run that ended with the bank’s seizure on March 10.
The US banking system currently has hundreds of billions in unrealized losses hidden in its system that have not weakened the buffers designed to protect banks from future shocks. Why would regulators allow this?
Short answer: Compromise.
Years ago, US supervisors decided that most small and medium-sized institutions could choose to deduct paper losses on bonds above key regulatory capital levels. In essence, these banks are allowed to report assets that are stronger in theory than they are in practice. As Silicon Valley banks — and the wider investing public — found out earlier this month.
Although giant banks no longer have this option as a result of post-2008 banking reforms, they have another way to ensure that sudden changes in the value of their securities do not damage the capital levels required by regulators: they sell bonds. Can move from one internal accounting category to another.
‘A good deal’
The debate about these paper losses began three decades ago with an accounting change that gripped the banking world.
A Rules from the 1993 Financial Accounting Standards Board Companies are required to undertake classification of fair market values of debt securities in specified manner. Any bonds that they intended to hold until maturity would be routed to a classification called “Hold to Maturity”, while bonds that could be sold sooner would go to a category called “Available for Sale”.
Any deterioration in the latter category will be visible in a bank’s public disclosures for anyone to see, but they will not be counted as a loss of earnings until the deteriorating assets are actually sold.
Banks worried that if these paper losses mounted on their massive bonds they would be punished by the overseers. Their fears were fueled by an early proposal from the FDIC that required banks to reduce key regulatory capital ratios if unrealized bond losses surfaced in the available for sale category. the bankers pushed back, and FDIC agreed in 1995 Regulatory ratios will not be affected by fall in the value of debt securities. (Equities still had to be counted.)
“This approach is considered appropriate,” the regulator said in a ruling that year, citing potential volatility that could lead to unrealized losses in the form of “changes in interest rates”. When rates rise, the value of existing bonds declines.
Former FDIC chairman Bill Isaacs, now chairman of Secura/Isaac Group, said it was “a good deal”, adding: “[You] Banks cannot be forced to mark to market. Then they cannot be long-term lenders.”
Former FDIC examiner Alan Puwalski sees it differently.
He said, ‘There was a mistake from the beginning. A different approach “would have prevented some of what happened. The banks would have known this was going to affect my regulatory capital.” The FDIC declined to comment.
a capital buffer
What is regulatory capital and why is it so important?
Capital, also known as “equity”, allows a bank to absorb any changes in the value of its assets and to survive unexpected shocks. It is the literal difference between a bank’s assets (cash, loans and investments) and its liabilities (deposits and other types of funds).
Regulators require banks to keep key capital ratios above certain limits. These ratios increase if a bank makes more profit and loses money on loans or investments.
If these ratios are not high enough, the thinking goes, a bank can get into serious trouble during times of stress. Regulators, as a result, use them to issue warnings and take corrective action.
Should these measures of strength be affected by unrealized bond losses that surfaced again after the 2008 financial crisis, when an international consortium operating under the name Basel III, proposed paper losses on “available for sale” securities from the bank’s regulator? To be reduced capital level. Specifically, a measure known as common equity Tier 1 capital.
US regulator considered adopting this proposal And faced pushback from banks and some public officials. His deal? This rule will only apply to banks that have more than $250 billion in assets small banks can exit, Regulators raised the bar in 2019 to include only Banks with over $700 billion in assets,
Giants like JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C), or Wells Fargo (WFC) are too big to leave out of this reporting scheme.
Instead these banks are able to move securities from “available for sale” to “hold to maturity”, a classification which means that unrealized losses will not affect the bank’s regulatory capital ratio. For example, most of the bonds held by Bank of America are now in that bucket — at the end of 2022, its unrealized loss Those holdings had a shortfall of just $109 billion.
‘Once the horse has left the barn’
Some of these practices may have changed after the collapse of Silicon Valley Bank, as many banks opted to reduce paper losses from regulatory capital ratios.
Federal Reserve can be As reported by The Wall Street Journal, propose changes in the coming months that would require more banks to end the practice. Across all US banks, unrealized losses had risen to $620 billion at the end of 2022.
Puwalski, a former partner at hedge fund Paulson & Co. and chief investment officer at Sybiont Capital, said, “The argument for soft capital treatment has always centered around the idea that fluctuating interest rates would create artificial volatility in bank capital. ” “What we have just experienced is that liquidity shocks can prove a fact that it is not artificial.”
Bank supervisors, he said, “have had at least two opportunities to get accounting practices right”, in the 1990s and after the 2008 crisis. Now he expects regulators to act aggressively.
“One thing [regulators] Good ones,” he said. “They actually lock that door after the horse leaves the barn.”
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