Why US regulators let banks lose billions as long as losses are ‘unrealized’

Silicon Valley Bank disclosed that it had a paper loss of $1.8 billion on several bonds at the end of 2022.

However, the lender did not reduce a key measure of capital strength monitored by regulators. Those losses become real to the bank when it is forced to sell these assets, causing a run-off. ended with the bank foreclosure on March 10.

The US banking system currently has hundreds of billions of unrealized losses hidden in its system without weakening a buffer designed to protect banks from future shocks. Why would the regulator allow that?

Short answer: Compromise.

Years ago, US watchdogs decided that most SME institutions could refuse to deduct paper losses on bonds from major regulatory capital levels. In essence, these banks are allowed to report assets that are stronger in theory than in practice. As a Silicon Valley Bank – and the broader investing public – discovered earlier this month.

However, the big banks don’t have this option due to banking reform after 2008, but they have another way to ensure sudden changes in the value of their securities do not affect the required capital level. Regulatory requirements: They can transfer bonds from one internal accounting category to another.

A Silicon Valley Bank sign in San Francisco.  (AP Photo/Jeff Chiu)

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

‘A good compromise’

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

ONE 1993 Rules from the Financial Accounting Standards Board requires companies to begin classifying the fair market value of debt securities in specific ways. Any bonds they intend to hold to maturity will be moved to a so-called “hold-to-maturity” classification, while bonds that can be sold earlier will be classified as “ready-to-sell” .

Any declines in the second category will show up in the bank’s public disclosures for anyone to see, but they won’t be considered a loss against earnings until the asset is down. Levels are actually sold.

Banks worry that they will be subject to punitive scrutiny if these paper losses are tied to the vast amount of bonds they hold. Their fears were further reinforced by an initial proposal from the FDIC to require banks to lower a key charter capital ratio if unrealized bond losses appeared in their available-for-sale portfolios. The banker pushed back, and FDIC agreed in 1995 specified rate will not reduce the value of the debt securities. (Equity still has to be counted.)

“This approach is deemed appropriate,” the regulator said in a ruling that year, citing the potential volatility that unrealized losses could cause as “interest rates change.” . As interest rates rise, the value of existing bonds tends to decrease.

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

Former FDIC judge Allen Puwalski has a different opinion.

“It was a mistake from the start,” he said. Another approach “would prevent certain things from happening. Banks would know this would affect my legal capital.” The FDIC declined to comment.

Capital buffer

What is legal capital and why is it so important?

Capital, also known as “equity”, is what allows a bank to absorb any change in the value of its assets and survive unexpected shocks. It is the literal difference between a bank’s assets (cash, loans, and investments) and liabilities (deposits and other forms of funding).

Regulators require banks to keep key capital ratios above certain thresholds. These ratios go up if the bank makes more profit and go down if the bank loses money on lending or investing.

If these ratios are not high enough, it is thought that a bank could run into serious problems during times of stress. As a result, regulators use them to issue warnings and take corrective action.

Are these strength measures affected by unrealized bond losses that resurfaced in the aftermath of the 2008 financial crisis when an international consortium, operating under the name Basel III, proposed deduct paper losses for “ready-for-sale” securities from bank regulation? capital levels. Specifically, a measure known as tier 1 common equity.

US regulatory agency consider passing this proposal and faced opposition from banks and some government officials. Their compromise? This rule will only apply to banks with more than $250 billion in assets while Smaller banks may refuse. Regulators raised the bar even higher in 2019 to include only The bank has assets of more than 700 billion USD.

Giants like JPMorgan Chase (JPM), Bank of America (NORTH), Citigroup (OLD), or Wells Fargo (WFC) is too large to opt out of this reporting program.

Instead, these banks can move securities from “ready-for-sale” to “hold-to-maturity,” a classification that means unrealized losses will not affect the capital ratio. bank regulation. For example, most bonds held by Bank of America are currently in that group – by the end of 2022, unrealized losses on those holdings is just $109 billion.

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

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

‘Once the horse is out of the stable’

Some of these practices may change after the fall of Silicon Valley Bank, as many banks have chosen not to deduct paper losses from their charter capital ratios.

The Federal Reserve can, According to a report in The Wall Street Journal, proposed changes in the coming months requiring more banks to end this practice. Across all US banks, unrealized losses skyrocketed to $620 billion by the end of 2022.

Puwalski, a former partner at hedge fund Paulson & Co. and chief investment officer at Cybiont Capital, said: “The underlying rationale for tolerant capital treatment has always revolved around the idea that interest rate fluctuations will create artificial volatility in bank capital.” “What we have just experienced are liquidity shocks that can prove a fact that it is not a fake at all.”

Bank supervisors, he added, “had at least two chances to get the accounting right” in the 1990s and after the 2008 crisis, he now expects regulators to act. positive action.

“One thing [regulators] It’s good, he says, that “once the horse has left the stable, they literally slam the door.”

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