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We shared this NBER paper on interest rate hedging by US banks in Further Reading earlier this week, but given FTAV’s interest in the subject we thought it warranted a closer look.
The tl;dr is that US banks only rarely use derivatives to hedge the interest rate risk on their massive bond portfolios. Instead, when rates go up they have mostly just reclassified the instruments from “available for sale” to “held to maturity”. The former gets marked to market; the latter is marked at par value.
The more vulnerable the bank, the more likely they were to engage in a bit of accounting jiggery-pokery, the NBER paper by João Granja, Erica Xuewei Jiang, Gregor Matvos, Tomasz Piskorski and Amit Seru concludes. FT Alphaville’s emphasis below:
In the face of rising interest rates in 2022, banks mitigated interest rate exposure of the accounting value of their assets but left the vast majority of their long-duration assets exposed to interest rate risk. Data from call reports and SEC filings shows that only 6% of U.S. banking assets used derivatives to hedge their interest rate risk, and even heavy users of derivatives left most assets unhedged. The banks most vulnerable to asset declines and solvency runs decreased existing hedges, focusing on short-term gains but risking further losses if rates rose. Instead of hedging the market value risk of bank asset declines, banks used accounting reclassification to diminish the impact of interest rate increases on book capital. Banks reclassified $1 trillion in securities as held-to-maturity (HTM) which insulated these assets book values from interest rate fluctuations. More vulnerable banks were more likely to reclassify.
This meshes with a paper published last year that looks at the interest rate swap positions of the largest 250 US banks, and concludes that they were “not economically significant in hedging the interest rate risk of bank assets”.
Indeed, the more recent NBER paper finds that even the biggest and most sophisticated banks were hedging less than a third of their securities, and that almost two-thirds of US banks do not report any hedges at all. That might seem curious, given that with an average duration of 4.6, every 2 percentage point move in the 10-year US Treasury yields would inflict about $2tn of aggregate losses. Which is real money even these days.
Despite what some of the zanier parts of the internet might say, letting banks classify much of their bond holdings as HTM — and therefore not marking them to market — does make sense. You wouldn’t want a bank’s profits and capital constantly yanked up and down by bond market volatility on ultra-safe US Treasuries and agency debt.
And as FTAV has pointed out before, hedging HTM books would in practice function as an interest rate bet: the hedge would move in tandem with interest rates while the accounting value of the underlying bonds would not.
However, pre-2022 most of US banks’ bond portfolios were actually classified as “available for sale”, presumably because the near-one-way movement of yields over the past four decades made it seem like a canny way to make a bit of extra money.
Hardly hedging these portfolios even when rates were floored — and then simply quietly shuffling a massive chunk of them over to HTM when interest rates began to climb — is . . . not a great look.
From Granja, Jiang, Matvos, Piskorski and Seru’s paper, with FTAV’s emphasis below:
At the beginning of 2022, about one-third of the $6 trillion of securities held by commercial banks were valued using HTM accounting. Banks transferred almost $1 trillion of their existing AFS securities to HTM during 2021 and 2022, thus avoiding recognizing losses on these assets simply by using a new accounting label. By the end of 2022, the share of bank securities valued using HTM increased to 45%, or $2.75 trillion. Based on our estimation, U.S. banks were able to avoid recognizing $175 billion in losses due to these reclassifications at the end of 2022. Instead of hedging the market value of assets against interest rate risks, the banks actively sought to insulate the book value of their assets, regulatory capital, and statements of income from declining market prices.
We also document that the least healthy and least stable banks were more likely to reclassify securities to HTM. Banks with lower capital ratios, a higher share of run-prone uninsured depositors, and longer-duration securities were more inclined to reclassify securities from AFS to HTM during 2021 and 2022. For instance, only one percent of banks reclassified securities from AFS to HTM if they relied on uninsured deposits for less than 20% of their total deposit funding. In contrast, over ten percent of banks with uninsured deposits accounting for more than half of their deposit funding reclassified securities from AFS to HTM. These effects are particularly pronounced for banks financing longer-duration securities portfolios with a substantial share of run-prone uninsured deposits.
So why were weaker banks allowed to get away with such naked accounting arbitrage to make themselves look less weak?
The accountants themselves were no check, obviously. When it came to the predilection for tactical reclassifications the paper finds little difference between banks audited by “the reputed Big-4” firms and smaller accountancies.
It does show that banks regulated nationally rather than locally were less likely to engage in such sleight-of-accounting, but that it didn’t make much overall difference.
The actions by banks we document bear resemblance to a classic “gambling for resurrection” strategy: in the scenario if runs do not occur, equity would have reaped profits, but in the case of the run, uninsured debtors and the FDIC would absorb the losses. Moreover, our findings cast doubt upon whether auditors and supervisors were able to assure that the reclassifying banks had the ability to hold these securities until their maturity.
Further reading:
— How crazy was Silicon Valley Bank’s zero-hedge strategy? (FTAV)
— Learning British financial stability lessons (FTAV)
