Banks’ hidden losses are surprise survivor of 2023

Paper cuts. One of the supposedly good things about financial crises is that, when the smoke clears, the loose ends that helped cause the problem are tied up once and for all. The implosion of SVB Financial and three other mid-sized U.S. banks in March was such an opportunity. Yet one feature of that mini crash has proved a surprise survivor of 2023: The weird and unhelpful treatment by banks of unrealized losses on securities.These paper deficits represent the hit that a bank would take if it sold something it currently owns at the market price. An example would be bonds whose value falls as interest rates rise. If there’s no market price, banks can base the valuation on other market inputs or in-house models. If the lender has the intent and ability to hold the investment until it matures, the unrealized loss remains theoretical.But sometimes reality intrudes, as SVB showed. The California lender had unrealized losses on government bonds and mortgage-backed securities equivalent to a large part of its capital. When depositors suddenly whipped out their cash the bank had to dump bonds, creating actual losses. The saga might have prompted regulators to avoid a future repeat. Yet banks continue to pile up losses that do not impact their earnings.Most bank balance sheets consist largely of loans. Institutions generally hold these assets at their value when they extended the credit, minus repayments or bad debt provisions. But when a bank buys a bond or another security, it has three broad options from an accounting perspective.The simplest option is to classify securities at their market value. This is the case for trading assets, which are more likely than not to be sold at short notice. But banks can also classify as “held to maturity” assets they have no plan to sell. These sit on the lender’s balance sheet at the purchase price, plus any minor adjustments.Around one-tenth of all global bank assets are in this second bucket, according to the International Monetary Fund. Banks largely ignore unrealized losses and gains from market fluctuations on these securities, only mentioning them in accounting footnotes. These paper losses have risen sharply. At U.S. banks, HTM losses hit a record $390 billion in the third quarter, according to the Federal Deposit Insurance Corp.For assets that a bank deems “available for sale”, things get fiddly. Banks report unrealized losses, but these don’t affect earnings. Instead, banks subtract the deficit from the equity on their balance sheets. In the United States, regulators ignore those items when calculating regulatory capital ratios for all but the biggest banks. Under recently proposed new rules, the tougher treatment may soon apply to all banks with over $100 billion in assets.The problem is that the difference between HTM and AFS assets is the banker’s intent. To decide whether a bank will really hold a bond until it matures, an investor needs a crystal ball – or a spreadsheet that indicates whether a bank might have to raise some extra cash. The result leaves room for ambiguity.The last time U.S. watchdogs proposed valuing almost all assets at fair value after the financial crisis, banks and their lobbyists complained loudly. They argued that swings in the market value of securities would cause their regulatory capital levels to gyrate, destabilizing the whole business. In a familiar response to proposed tougher rules, banks said this would reduce their willingness to lend and invest.Yet not everyone is a fan of the current rules, which as JPMorgan chief Jamie Dimon has pointed out tie bank executives’ hands. Under a process called “tainting the portfolio”, shifting just one bond from HTM to AFS requires the bank to reclassify the rest, potentially recognizing losses. So banks are stuck holding bonds they might otherwise offload and reinvest in something more attractive. Bank of America shows the pros and cons. Shareholders would clearly prefer it not to recognize its paper losses of over $130 billion. At the same time, boss Brian Moynihan cannot sell those underwater investments piecemeal, even if he wants to.The danger posed by unrealized losses depends on which bank holds them. SVB had to dump its bonds and crystallize losses because large depositors rapidly pulled out cash. Bank of America doesn’t face that problem, and investors understand the difference. A lender with big unrealized losses which relies on a smaller number of high-value deposits is riskier than a bank with tens of millions of small accounts, like Bank of America and its large peers.Even so, there’s no standardized way of presenting that information in a clear way. And there’s no bright red line after which a bank becomes vulnerable to a run. The chance of JPMorgan, Bank of America or other large banks having to hold a fire sale of their held-to-maturity assets seems close to nil. For smaller regional lenders, the probability, while low, rises.One way to solve the problem would be to do away with the fuzzy accounting treatment of securities and force banks to value everything at the prevailing market price. If the concern is that the shift would make bank capital too volatile, regulators could smooth out short-term swings by averaging valuations over a few quarters when they calculate how much equity a bank holds versus how much it needs.Yet watchdogs are unlikely to tie up this loose end any time soon. Change would require a tortuous process led by the Financial Accounting Standards Board in the United States, and the International Accounting Standards Board elsewhere. Moreover, banks are touchy about reforms that affect their reported profit or capital. U.S. lenders are already fighting viciously to sink proposals that might raise their capital requirements by more than a quarter.That’s a shame because the current treatment is far from rational. Even Warren Buffett, the famously long-term investor who laments the unhelpfulness of having to mark his investments to market every quarter, is unsympathetic to bank accounting. At his annual meeting this year, he and late partner Charlie Munger sat behind name plates labelled “AVAILABLE FOR SALE” and “HELD-TO-MATURITY”.Investors may have learned to navigate this counterintuitive accounting pothole. Nonetheless, it would be better if the current treatment of unrealized losses did not survive another year.Context NewsBanks in the United States had $684 billion of unrealized losses on their securities investments at the end of September, a 22% increase on the preceding quarter, according to a report from the Federal Deposit Insurance Corp published on Nov. 29. Losses on securities that banks classify as “held to maturity” hit a record $390 billion. Lenders do not have to recognize market fair value of securities they never intend to sell, though banks disclose the theoretical losses a sale would produce in accounting footnotes. Bank of America had $132 billion of unrealized losses in its held-to-maturity portfolio at the end of September, made up of government bonds and mortgage-related securities guaranteed by official agencies.Author: John Foley

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Banks’ hidden losses are surprise survivor of 2023

Banks in the US had $684 billion of unrealised losses on their securities investments at the end of September, a 22% increase on the preceding quarter.

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