Why US regulators are letting banks lose billions – as long as losses are “unrealized”.

Silicon Valley Bank announced it had $1.8 billion in paper losses on some bonds at the end of 2022.

And yet the lender hasn’t reduced a key capital strength metric monitored by regulators. Those losses became existential for the bank as it was forced to sell those assets, sparking a run that ended with the bank’s seizure on March 10.

The US banking system currently has hundreds of billions in unrealized losses lurking in its system, which does not weaken the buffers designed to protect banks from future shocks. Why would regulators allow that?

The short answer: compromise.

Years ago, US regulators ruled that most small and mid-sized institutions could opt out of deducting paper losses on bonds from key regulatory capital levels. In essence, these banks are allowed to report assets that are theoretically stronger than they would be in practice. As Silicon Valley Bank — and the wider investing public — found out earlier this month.

However, giant banks don’t have that option because of the post-2008 banking reform, but they do have another way of ensuring that sudden changes in the value of their securities don’t affect the capital levels required by regulators: they can move bonds from one internal accounting category to another.

A sign for a private branch of Silicon Valley Bank is displayed in San Francisco on Tuesday, March 14, 2023. (AP Photo/Jeff Chiu)

“A Good Compromise”

The debate surrounding these paper losses began three decades ago with an accounting change that gripped the banking world.

A 1993 Rule of the Financial Accounting Standards Board required companies to begin classifying the market values ​​of debt securities in certain ways. Any bonds they wished to hold to maturity would go into a classification called “held to maturity,” while bonds that could be sold sooner would go into a category called “available for sale.”

Any declines in the latter category would appear in a bank’s public disclosures for all to see, but would not count as a loss against earnings until the deteriorating assets were actually sold.

Banks feared that if these paper losses boosted their massive bond holdings, they would be penalized by supervisors. Their fears were heightened by an early FDIC proposal that banks should lower key regulatory capital ratios when unrealized bond losses occurred in the available-for-sale category. Bankers pushed back, and the FDIC agreed in 1995 regulatory metrics would not suffer from falls in the value of debt securities. (Shares still had to be counted.)

“This approach is considered appropriate,” the regulator said in a ruling this year, citing potential volatility that could represent unrealized losses on “interest rate changes”. When interest rates rise, the value of existing bonds tends to fall.

Former FDIC Chairman Bill Isaac, who now chairs the Secura/Isaac Group, said it was “a good compromise,” adding, “[You] cannot force banks to value at market prices. Then they can’t be long-term lenders.”

Former FDIC examiner Allen Puwalski sees it differently.

“It was a mistake from the start,” he said. A different approach “would have stopped some of what was happening. The banks would have known this would 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 changes in the value of its assets and weather unexpected shocks. It is the literal difference between a bank’s assets (cash, loans and investments) and its liabilities (deposits and other forms of funding).

Regulators require banks to maintain key capital ratios above certain thresholds. These ratios increase when a bank makes more profits and decrease when it loses money on loans or investments.

If these ratios are not high enough, the reasoning goes, a bank could run into serious problems in times of stress. Regulators therefore use them to issue alerts and take corrective action.

Whether these measures of strength should be affected by unrealized bond losses resurfaced after the 2008 financial crisis, when an international consortium operating under the name Basel III proposed deducting paper losses on “available-for-sale” securities from a bank’s prudential capital levels . Specifically, a measure known as Tier 1 hard capital.

American regulators considering accepting this proposal and was pushed back by banks and some officials. your compromise? The rule would only apply to banks with assets of more than $250 billion smaller banks could exit. Regulators raised the bar in 2019 to just include Banks with assets in excess of $700 billion.

Giants like JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C) or Wells Fargo (WFC) are too big to opt out of this reporting system.

Instead, these banks can switch securities from available-for-sale to held-to-maturity, a classification that means unrealized losses do not affect a bank’s regulatory capital ratios. Most of the bonds held by Bank of America, for example, are in this bucket right now — it will be in late 2022 unrealized losses on these stocks were just under $109 billion.

President Joe Biden addresses the economy during a meeting with CEOs in the South Court Auditorium of the White House complex on Thursday, July 28, 2022 in Washington.  Bank of America CEO Brian Moynihan appears on the right of the screen.  (AP Photo/Susan Walsh)

President Joe Biden addresses the economy during a meeting with CEOs in the South Court Auditorium of the White House complex on Thursday, July 28, 2022 in Washington. Bank of America CEO Brian Moynihan appears on the right of the screen. (AP Photo/Susan Walsh)

‘As soon as the horse has left the stable’

Some of these practices may change following the collapse of Silicon Valley Bank, which like many banks has refrained from deducting paper losses from regulatory capital ratios.

The Federal Reserve can according to a report in the Wall Street Journal, Proposing changes in the coming months that will require more banks to end the practice. For all US banks, unrealized losses had risen to $620 billion by the end of 2022.

“The rationale for lenient capital treatment has always been the idea that interest rate movements would create artificial volatility in bank capital,” said Puwalski, a former partner at hedge fund Paulson & Co. and chief investment officer at Cybiont Capital. “What we’ve just witnessed is that liquidity shocks can prove it’s not artificial at all.”

Banking regulators, he added, “had at least two opportunities to get accounting right in the 1990s and after the 2008 crisis.” Now he expects aggressive action from the regulatory authorities.

“One thing [regualtors] good at it,” he said, “when the horse’s out of the stable, they really slam the door.”

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Source : finance.yahoo.com

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