Silicon Valley Bank (SVB) failed because it invested too much in long-term bonds that lost value when interest rates went up. That’s what our accounting rules encourage banks to do. As a consequence, U.S. banks, including some of America’s leading banks, are estimated to have over $600 billion of unrecognized losses on the “underwater” securities on their books.
The accounting rules that encourage risk-taking permit banks to show values for bonds on their balance sheets that are not the real values. Instead, they are the prices that the banks paid for the bonds (called “historical cost”), even if the bonds have decreased in value, as they always do when interest rates go up.
Carrying securities at historical cost encourages banks to take risks. Management bonuses usually are based on reported earnings or, in the case of SVB, return on equity (ROE), which is earnings divided by equity capital. Reported earnings include the interest paid on securities that the bank owns. Because the interest rate yield curve usually is upward-sloping, longer-term securities usually pay more interest than shorter-term securities. Therefore, in the short run, management gets bigger bonuses by buying longer-term securities. By buying long-term securities that paid an average of 1.5% instead of safe one-year Treasury Bills, the bank more than doubled SVB’s 2022 income and its ROE. With this system, the extra benefits to CEO Becker and CFO Beck were in the millions.
However, the longer maturities exposed SVB to losses when interest rates went up–except that the accounting rules allowed the bank not to count the losses in their reported income. Nor was the bank required under accounting rules to report the unrealized losses on their securities as the Fed continued to drive interest rates up in its campaign to slay inflation. By Mar. 31, 2022, SVB already had about $7 billion in market value loss. If it sold any of its underwater securities to shorten the average maturity of its holdings and thereby to reduce its downside if rates continued to go up, it would have had to recognize that $7 billion loss. And if it recognized that loss, it would have lost almost half of its equity capital of $16 billion and would have been in danger of failing. Instead, it chose to roll the dice.
By the end of the year, as rates continued to rise, SVB’s market value loss had more than doubled. And the jig truly was up. In banking jargon, balance sheet flexibility is…
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