Accounting procedures for held-to-maturity assets in banks allows them to avoid taking losses. Research from professors Bischof, Laux, and Leuz shows how forcing banks to mark  their assets to market and thus recognize their losses earlier sets incentives for banks to take remedial action sooner.

After a plane crash, the Federal Aviation Administration conducts an investigation into the cause and often changes the rules to prevent similar accidents in the future. The agency has been so successful in ensuring airline safety in fact, that their sterling record in recent years defies the odds

The same cannot be said for U.S. financial regulators.

In conducting their own crash-analysis of the 2008 financial crisis, professors Jannis Bischof, Christian Laux and Christian Leuz found that U.S. banks, just like their international peers, are reluctant to reveal and recognize their losses. Bank managers’ reporting incentives mean that they communicate about relevant risks often later than investors or regulators would prefer.

The authors say that by the time banks provided disclosures or recognized losses in the 2008 financial crisis, major concerns about banks’ exposures had already arisen in markets through other channels.

One way that risk is obscured is through ‘hold-to-maturity’ allocations. This allows the bank to record an asset’s value at the price it was bought at (historical cost), rather than recording the current market price.

A debate ensued about the hold-to-maturity’ designation after the financial crisis of 2008. Banks and the American Bankers Association (ABA) argued that forcing banks to mark-to-market would accelerate financial instability in a crisis situation. However, this claim was largely unfounded in the last crisis according to an analysis conducted by the authors.

Regulators, banks, and the ABA also justify the accounting at historical cost by the seeming irrelevance of current changes in interest rates if banks do not have plans to sell these assets. Indeed, if banks only collect the contractual cash flows until maturity, the market price will revert to the nominal value of the loan (assuming there is little credit risk as there was for the treasury bonds held by SVB).

On the other side of the debate is a cohort of investors who dislike the hold-to-maturity framework. In the end, the accounting rules were changed for loans, moving to an expected loss model, but not for hold-to-maturity securities, which can still be recorded on bank balance sheets at their historical cost. The authors say that this decision proved costly in recent years when the Fed quickly raised interest rates.

Interest rate changes can have severe consequences not only for a bank’s hold-to-maturity portfolio, but for also its funding. When interest rates increase, depositors and money market investors are more likely to withdraw their short-term funds to use alternative investment opportunities at higher rates.

If too many investors withdraw their funds, banks will be forced to liquidate some of their assets, including those that they seriously intended to hold to maturity. Since this liquidation would occur at current prices, the assets’ current market price does matter after all. In this sense, there is a link between the valuation of the assets and banks’ funding structure, and the two cannot be viewed in isolation, the authors say.

Indeed, it was concerns about unrecognized losses in securities that triggered bank runs at Silicon Valley Bank (SVB) and others. They point out the link between recognizing losses and SVB’s unstable funding structure.

“SVB is a poster child for what we say in our paper and why we warn about the link,” Leuz told ProMarket. “They basically put treasuries into the hold-to-maturity category and did not mark these positions to market. But when depositors withdrew funds, they had to sell treasuries at a loss. So the current market prices became relevant, despite their initial intention.”

Therefore, the authors point out that it is important to link accounting measurement and the bank’s funding structure:

“For example, debt securities are recognized at historical cost if they are held to maturity for the collection of cash flows. A common justification for this accounting treatment is that market values are not relevant in this case (e.g., American Bankers Association, 2009 ). However, with short-term funding, such as wholesale deposits, banks essentially have to continuously roll over their funding, and such refinancing is akin to repeatedly selling a claim on a pool of assets at current market prices. Thus, a bank’s ability to hold assets to maturity or for the collection of cash flows does depend on interim market prices when it needs to roll over its funding. Banks’ funding structures are potentially more relevant for accounting measurement than either management’s intent or the bank’s business model, both of which is what the accounting standards reference.”

According to Bischof, Laux, and Leuz’s research, making banks recognize losses on these securities would force the banks to take corrective action sooner. They find that banks in countries that did not have a prudential filter for unrealized losses, meaning that losses hit their regulatory capital earlier, were more responsive to these losses in terms of taking corrective actions, such as raising capital, reducing risks, etc.

A similar logic applies to the held-to-maturity assets of SVB. The losses in the SVB case did not build up all in one month, the authors tell ProMarket. Moreover, had the bank known that those losses would hit the balance sheet and income statement, managers would have had a greater incentive to implement hedging strategies and better risk management in the first place. 

In an environment when the US Federal Reserve has been rapidly raising interest rates, the gap between book values of hold-to-maturity assets and their market values has swelled even for securities that have no default risk. The problem is thus greater than just the fall of SVB: As Seru, Jiang, Matvos and Piskorski pointed out in an earlier ProMarket piece: “the market value of U.S. banking system assets is $2.2 trillion lower than suggested by their book value if they were forced to sell the assets.”

There is a continued risk that banks will be forced to sell their assets to repay depositors who withdraw their funds, either because they fear more bank runs, or simply because they want to invest in securities that offer a more attractive yield. In the meantime, the authors say, banks that are not forced to write down the value of the securities to their market value are not forced to react. Instead, they can wait and hope that interest rates decrease again or that depositors do not withdraw their funds.

As recent events have re-ignited the mark-to-market debate once again, the authors tell ProMarket that it is time for regulators to implement the safety procedure that they neglected to enact after the last crash, by forcing banks to recognize market losses even on assets they intend to hold to maturity, when their funding structures are instable. Otherwise, we will continue to see the same type of accidents and failures again. 

Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.