In Brief

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The failures of Silicon Valley Bank, Signature Bank of New York, and First Republic Bank in 2023 shocked observers and have since led to investigations by regulators and researchers aimed at understanding the root causes. The problems are multifaceted and sources of blame—including bank executives, statutory changes, and accounting standards—are plentiful. The article looks specifically at the shortcomings of the held-to-maturity (HTM) approach of accounting for securities with unrealized losses and how it may have in hindsight obscured the risks these banks facing in the prevailing interest rate environment.

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The U.S. Federal Reserve’s steady increases in the Effective Federal Funds Rate starting in March 2022 exerted pressure on certain banks that failed to properly manage interest rate, maturity, and duration risks (http://tinyurl.com/bdcdaxem). These fundamental banking risks, while well understood and even quantifiable to a large degree, were ignored or dismissed by certain bank boards and executives. Some contend this was done in order to increase profitability in 2021 and 2022. Although unrealized losses on securities designated as “held-to-maturity” (HTM) rose to significant amounts for many banks in 2022, these were not reflected on the face of their financial statements, but rather disclosed in the balance sheet details and notes. As of May 2023, it was estimated that the total unrealized HTM losses facing U.S. banks were more than $2 trillion, according to Stanford University Professor Amit Seru (http://tinyurl.com/4h5xb3p2).

Interest rates in 2020 and 2021 were at historic lows as the Federal Reserve sought to mitigate economic damage from the COVID-19 pandemic crisis. To wit, 3-month T-Bill rates were at essentially zero from early 2020 to the beginning of 2022 before rising to over 5% in 2023 (http://tinyurl.com/bdcdaxem).

Depositors who were happy to keep funds in low-paying deposits started to move their funds in mass to higher-yielding deposits in late 2022 and early 2023. Often, the amounts exceeded the $250,000 of Federal Deposit Insurance Corporation (FDIC) protection and thus were uninsured (per governmental reports, discussed below, Silicon Valley Bank (SVB) and Signature Bank of New York (SBNY) at the end of 2022 had over 80% worth of uninsured deposits. SVB, SBNY, and First Republic Bank (FRB) were the first to fail, leading to concerns that banks nationwide, particularly regional banks, could face similar liquidity problems and possible runs. Silvergate Bank of California technically did not fail, but in 2023, it self-liquidated as it came under depositors’ withdrawal stress (http://tinyurl.com/4z49rf6x). Prior to this, the last previous FDIC bank failures were in 2020 (http://tinyurl.com/27aycbcc).

At Berkshire Hathaway’s May 2023 annual meeting, Warren Buffett, anticipating questions on the U.S. banking system, had two signs reading, HTM and Available-for-Sale (AFS). The issue of whether HTM unrealized losses should flow to the bottom-line earnings has historically been debated after previous banking crises (e.g., the 2008 subprime crisis, and previously the 1989/1990 Savings and Loan crisis; see http://tinyurl.com/np4j5pus). No doubt this debate will begin again.

This article examines the growing unrealized HTM losses, the 2022 annual audit reporting of HTM losses, and the regulatory reports on the SVB and SBNY bank failures, all within the context of fundamental interest rate, maturity, and duration risks as well as their implications for the banking and accounting professions. HTM unrealized losses are typically not realized if a bank can hold a debt instrument until maturity, as they often are U.S. government securities (essentially risk-free from a principal perspective). The degree to which unrealized HTM losses are playing in the current banking crisis is debatable as the problems are multifaceted (e.g., poor management, heavy exposure to uninsured deposits, profit focus). Sources of blame are plentiful; these include bank executives, Congressional statutory changes, regulators, credit rating firms, and potentially FASB bank accounting standards.

Growing Unrealized Losses on HTMs

A focal accounting issue in the early 2023 bank failures is that a bank does not include any unrealized losses in their income statement earnings when their securities are classified as HTM. As stipulated in the summary of SFAS 115 (emphasis added):

  • ▪ “Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost.”
  • ▪ “Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.”
  • ▪ “Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders’ equity.”

Although SFAS 115 (effective of December 15, 1993) has been superseded, subsequent FASB guidance (e.g., ASU 2016-13 and 2022-01), although “not authoritative,” states that securities purchased be classified under these categories on the date. See the sidebar, Accounting for Held-to-Maturity versus Available-for-Sale, for the basic financial reporting of HTM and AFS debt securities.

As SVB’s 2022 10K states, “Securities classified as HTM are accounted for at cost with no adjustments for changes in fair value” (http://tinyurl.com/2y2jf5j5).” HTM securities are required to be reported at amortized cost, which is defined by the FDIC as follows:

In general, amortized cost is the purchase price of a debt security adjusted for amortization of premium or accretion of discount if the debt security was purchased at other than par or face value. (http://tinyurl.com/2hh38dnc)

 

Unrealized gains and losses are disclosed in the notes to the financial statements. SBNY’s 2022 financial statement footnote 4 on securities states that if they intend to sell a security, an unrealized loss is charged through earnings (p. 143).

Exhibit 1 reports key 2021 and 2022 HTM numbers for SVB, SBNY, and FRB from their balance sheets. An overall trend is clear: as interest rates rose in 2021 and 2022, the unrealized losses grew significantly. As of 2022, HTM unrealized losses were growing to material amounts for these banks prior to their failures. As of December 31, 2022, SVB’s HTM unrealized losses were approximately 16.6% of the total amortized cost, 9.8% for SBNY, and 16.8% for FRB. This compares to 2021, when HTM unrealized losses were relatively immaterial, at less than 1% for SVB, 1.06% for SBNY, and a gain of 5.07% for FRB.

Exhibit 1

Growing Unrealized HTM Losses

2021; 2022 Amortized Cost; Unrealized Losses/Gains; Losses/Gains; Amortized Cost; Unrealized Losses; % of Losses/Gains SVB; $98,195; ($968); −0.99%; $91,321; ($15,152); −16.59% SBNY; $4,998; ($53); –1.06%; $7,780; ($762); −9.79% FRB; $22,292; $1,130; 5.07%; $28,348; ($4,761); −16.79% In millions, calculated from 2022 10K Balance Sheets. SVB, Silicon Valley Bank; SBNY, Signature Bank of New York (SBNY); FRB, First Republic Bank

Factoring in the increases in unrealized losses from 2021 and 2022 into these entities’ income statements would have material negative effects on inferred earnings per share (EPS), as estimated in Exhibit 2. For SVB and FRB, EPS would turn substantially negative if unrealized losses were incorporated; for SBNY, the EPS would remain positive but drop over 50%. Although Exhibit 2 is a simplification, it shows that full recognition of unrealized losses in EPS in 2022 would have drastically changed the reported headline numbers on EPS.

Exhibit 2

Inclusion of 2022 Unrealized HTM Losses in EPS, Basic

SVB; SBNY; FRB 2022 Net Income Available to Common Shareholders; $1,509; $1,301; $1,507 Increase in HTM Losses in 2022; ($14,184); ($709); ($5,891) Inferred Net Income if Realized; ($12,675); $592; ($4,384) Inferred EPS factoring in HTM Losses—basic; ($214.88); $9.50; ($24.22) Reported EPS—basic; $25.58; $20.88; $8.32 In millions, except per share amounts. Inferred EPS is calculated by dividing inferred net income by the weighted average number of outstanding shares.

Exhibit 2 raises the question of whether bank managers would manage interest rate risks more proactively if they knew that unrealized losses would flow to reported EPS. In the case of Silicon Valley Bank Financial Group (SVBFG), the opposite occurred, according to the Federal Reserve:

In July 2022, SVBFG removed the rest of the hedges protecting NII [Net Interest Income] from rising rates, and management started to think about adding hedges to gain NII if rates were to decrease. SVB remained steadfast in its commitment to protecting NII in down-rate scenarios but did not protect against rising rate environments. (http://tinyurl.com/54mmm5uz, p. 64)

 

Banks that had sought extra returns with purchases of longer-dated government and mortgage bank securities in 2020/2021, when short-term rates were essentially zero, were faced with millions and even billions of dollars unrealized losses on these obligations that were not reflected in their core earnings in 2022. Although U.S. government-backed debt securities are considered among the safest investments, they are subject to interest rate, duration, and maturity risks such as occurred in 2022 and 2023. As depositors moved their funds to higher-yielding options, these banks were often faced with having to sell their longer-maturity securities at deep losses in 2023. As noted above, U.S. banks were facing unrealized HTM losses estimated at more than $2 trillion in aggregate as of early 2023. For example, Bank of America, Warren Buffett’s second-largest holding as of March 31, 2023 (http://tinyurl.com/ye2395dx), reported $108.6 billion in unrealized losses on HTM securities in its 2022 annual report (http://tinyurl.com/ycxbrzt4).

Regulatory Reports on Bank Failures

In 2023, the U.S. Board of Governors of the Federal Reserve System (“Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank,” http://tinyurl.com/54mmm5uz) and the FDIC (“FDIC’s Supervision of Signature Bank,” http://tinyurl.com/484mzz2u) quickly released reports on the SVB and SBNY March 2023 bank failures:

The FDIC report observed the following with respect to SBNY:

The primary cause of SBNY’s failure was illiquidity precipitated by contagion effects in the wake of the announced self-liquidation of Silvergate Bank, La Jolla, California (Silvergate), on March 8, 2023, and the failure of Silicon Valley Bank, Santa Clara, California (SVB), on March 10, 2023, after both experienced deposit runs. However, the root cause of SBNY’s failure was poor management. (http://tinyurl.com/484mzz2u)

 

As particular banks quickly faced liquidity crises, many questioned why government regulators and bank auditors had not seen this coming. On March 13, 2023, a Wall Street Journal headline announced: “KPMG Gave SVB, Signature Bank Clean Bill of Health Weeks Before Collapse: Accounting firm faces scrutiny for audits of failed banks” (http://tinyurl.com/ec6rvyax). Both SVB and SBNY had uninsured deposits of more than 80% at the end of 2022. These deposits are “prone to rapid runoff,” per the FDIC report. Bank regulations were tightened after the Global Financial Crisis of 2008–2009 and under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (e.g., bank stress tests). The Dodd-Frank Act, however, was amended by the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) of 2018, and some contend that this action watered-down bank regulation. Rohit Chopra, FDIC voting board of director member, stated on CNBC on May 12, 2023, that the recent bank failures showed “lax oversight and regulatory rollbacks” (http://tinyurl.com/3fs8zyff). Relative to supervisory oversight, the Federal Reserve report on the SVB failure stated, “A shift in the stance of supervisory policy impeded effective supervision by reducing standards, increasing complexity, and promoting a less assertive supervisory approach” (http://tinyurl.com/54mmm5uz, p. 9). Both SVB and SBNY had weak corporate governance, according to the Federal Reserve and FDIC 2023 review reports.

A key regulatory measure for banks is the “Camels” rating system, which has six components that measure bank soundness; it is described in 2023 FDIC report as follows:

Bank examiners review and evaluate an institution’s condition using the Uniform Financial Institutions Rating System, also known as CAMELS (Capital, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk). CAMELS ratings are scored on a scale of “1” (best) to “5” (worst). Examiners assign a rating for each CAMELS component and an overall Composite rating. (http://tinyurl.com/484mzz2u, p. 3, fn. 1)

 

Both SVB and SBNY generally had Camels overall composite ratings of “2” from 2017 to 2022 (SVB’s Camels rating declined to 3 in August 2022).

Both reports noted that supervisory/compliance resources were challenges regarding these banks. Liquidity risk management, uninsured deposits, rapid growth, internal controls, and focus on growth/profits, were all cited as problematic. During the FDIC’s review period, SBNY’s uninsured deposits ranged from 63% to 82% of total assets. A 2023 GAO report referenced by the FDIC found that similar banks had uninsured deposits averaging between 31% to 41% (http://tinyurl.com/484mzz2u, p.10). In the fourth quarter of 2022, a staggering 94% of SVB deposits were uninsured (http://tinyurl.com/54mmm5uz, p. 21). Corporate governance deficiencies were cited for both banks. SBNY’s management was stated by the FDIC to be “generally dismissive of examination findings” (http://tinyurl.com/484mzz2u, p. 9). In the Federal Reserve report on the SVB failure, it was stated, “SVBFG’s growth far outpaced the abilities of its board of directors and senior management” (http://tinyurl.com/54mmm5uz, p. 46). Just before the March 13, 2023, SBNY failure, the FDIC report observed the following:

SBNY management still did not believe it could fail, fervently maintaining “SBNY is not like WaMu or IndyMac.” SBNY’s President rejected examiner concerns about the stability of uninsured deposits as late as noon EST on March 10, 2023. Bank management failed to acknowledge the severity of the problem until a run started on SBNY in the afternoon. (http://tinyurl.com/484mzz2u, p. 15)

 

When Washington Mutual Bank (WaMu), with over $300 billion in assets, failed in September 2008, it was the largest FDIC bank failure of its time (http://tinyurl.com/42m3aazr). IndyMac Bank, with $32 billion in assets, failed in July 2008 (http://tinyurl.com/mpw2bbj4). SVB had over $210 billion in assets prior to its failure (http://tinyurl.com/54mmm5uz, p. 2). SBNY, prior to its failure, was the 29th largest bank in the United States with $120 billion in assets (http://tinyurl.com/484mzz2u, p. 2).

FDIC Insured Accounts

In general, the FDIC insures “up to at least $250,000 per depositor, per FDIC-insured bank, per ownership category” (http://tinyurl.com/2p9a47x3). However, in the case of the SVB, SBNY, and FRB bank failures, domestic depositors were made whole regardless of their bank balances. Deposits in overseas subsidiaries were not protected, however. In the case of SBNY, “Approximately 60 clients held deposit account balances in excess of $250 million, representing about 40 percent of total deposits.” (http://tinyurl.com/484mzz2u, p. 11).

This has led many to contend that the FDIC was, in theory, insuring all U.S. deposits, regardless of size, at all FDIC banks in early 2023 (http://tinyurl.com/5n7unekv). According to FDIC data, as of 2022, there were over 4,000 total commercial banks that were “FDIC-insured institutions.” This raises serious moral hazard questions as to whether the federal government is advocating or subsidizing excessive risk-taking on the part of banks and depositors. With the FDIC making whole depositors with hundreds of millions of dollars, this has caused some to question whether these depositors instead should be exercising due diligence about a bank’s safety and liquidity before placing massive excess funds in a single bank.

Interest Rate, Maturity, and Duration Risks

The SEC has an investor bulletin simply titled, “Interest Rate Risks—When Interest Rates Go Up, Prices of Fixed-rate Bonds Fall,” which states the following:

A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions. When market interest rates rise, prices of fixed-rate bonds fall. This phenomenon is known as interest rate risk. (http://tinyurl.com/2tybcj2m, p. 1)

 

This bulletin contains an example showing that even a 1% increase in interest rates on a $1,000, 10-year bond will cause the bond to lose nearly 10% of its value in one year (from $1,000 to $925).

In hindsight, this fundamental banking risk was given too little attention, as the Federal Reserve report on SVB stated:

While interest rate risk is a core risk of banking that is not new to banks or supervisors, SVB did not appropriately manage its interest rate risk, and supervisors did not force the bank to fix these issues quickly enough. (http://tinyurl.com/54mmm5uz, p. 3)

 

This rule of thumb of a 1% increase in interest rates resulting in an approximately 10% decrease in the value of a 10-year bond has major implications for the banking industry, as longer-duration holdings would continue to lose value if inflation and the Federal Reserve rate increases were to increase (although as of early 2024, this appears not to have occurred and longer-term U.S. 10-Year Treasury Note rates have fallen from their highs). In general, these unrealized losses can mount up quickly regardless of the quality of fixed income securities. As of December 31, 2022, SVB, SBNY, and FRB’s HTM holdings had the following duration (Exhibit 3). SBNY did not report its HTM duration on its 2022 10K, but it did report its securities portfolio duration debt duration of 4.23 years in 2022.

Exhibit 3

Weighted-Average Duration of HTM Debt

2022; 2021 SVB; 6.2; 4.1 SBNY; Only the overall duration reported FRB; 10.8; 10.6 Source: 2022 10Ks

Banks that hold longer-duration low-rate securities, regardless of credit quality (SBNY’s HTM holdings were, according to its 10K, all essentially “guaranteed by the U.S. Government”), would face material and quantifiable losses on these holdings if they were not able to hold them to maturity. SBNY’s 2022 10K management’ discussion on its securities portfolio includes a table on the impact of various “interest rate shocks” on its overall debt security holdings. (This table is partially reproduced in Exhibit 4). A score of 100 basis points equals a 1% increase in interest rates (in 2022, interest rates increased by approximately 5%).

Exhibit 4

SBNY Reported Change in Fair Value of its Debt Securities

Interest Rate Shock; Estimated Fair Value Change + 100 basis points; (4.21%) + 200 basis points; (8.58%) + 300 basis points; (13.01%) + 400 basis points; (16.99%) Source: SBNY 10K, page 92.

Another section of the Federal Reserve’s report on SVB, “Balance Sheet Mismanagement,” stated, “protecting profitability was the focus” (http://tinyurl.com/54mmm5uz, p. 77). Regulators contended that executive compensation packages tied to bank profitability likely played a role in SVB’s failure. Although a high-quality U.S. government debt obligation held to maturity will almost without question mature at face value, banks that are faced with liquidity runs will typically not have the ability to hold to maturity.

Prior HTM Reporting Debates

Some have questioned whether the accounting treatment of not recognizing unrealized HTM losses adds to bank managers’ willingness to take on more interest, duration, and maturity risks than are prudent (a moral hazard). As Warren Buffett stated on CNBC on April 12, 2023:

Bankers have been tempted to do that forever. Accounting procedures have driven some bankers to do some things that have helped their current earnings a little bit and caused the recurring temptation to get a little bit bigger spread on record, a little more than earnings. (http://tinyurl.com/3s2a2p9r)

 

After the 2008 subprime crisis and early 1990s Savings & Loan crisis, the accounting for HTM securities was debated. FASB in 2010 proposed that all financial instruments be reported at fair value, but banking industry opposition resulted in FASB keeping its traditional approach. Some bankers contend that the FASB needs to change its “current mixed-measurements model” accounting to be clearer to investors. As Brent Beardall, chief executive of Seattle-based bank Washington Federal Inc. was quoted in the Wall Street Journal, on March 20, 2023:

Fair value is a useful piece of information, but it’s only useful if you get all of the information. Picking and choosing is a disaster. I think it’s time that the FASB look at it and provide information to investors the way they want it. (http://tinyurl.com/378cw2dx)

 

The Benefit of Hindsight

Clearly, in hindsight, the risks faced by banks from rising interest rates in 2023 were not fully supervised by regulators. It is troubling that interest risks were not fully addressed by the Federal Reserve or FDIC’s oversight of banks and were possibly obscured by bank accounting standards for securities designated as HTMs. Although financial statements showed material unrealized losses as of the end of 2022 on HTM securities, this was mainly disclosed in the financial statements’ footnotes. While SVB, SBNY, and FRB faced many challenges, a major factor in their demise was the inability to hold HTM securities to maturity due to bank runs.

Some banks in 2023 faced financial stress due to the almost predictable situation that their low-rate long-term holdings (even if U.S. government-backed) would incur actual significant losses in fair value if interest rates rose and they were forced to liquidate. Depositors have shown their ability to quickly move funds to readily available higher-interest products. As the FDIC’s May 2023 report stated, “The speed with which depositors withdrew funds from SBNY and SVB was unexpected and surprised the regulators and the banking industry” (http://tinyurl.com/484mzz2u).

Many executives at well-run banks would contend that this turn of events was a predictable or even inevitable result of the Federal Reserve’s historical unwinding of stimulus programs to abate the economic effects of the pandemic. How large a role did accounting play with regard to HTM securities, wherein unrealized losses are not recognized in financial statement earnings? Should these unrealized losses be recognized once they reach a material amount, as occurred in 2022? As noted above, incorporating unrealized HTM losses directly into financial statements would have a material impact on stated earnings.

William M. VanDenburgh, PhD, is an associate professor of accounting at the College of Charleston, Charleston, S.C.
Philip J. Harmelink, PhD. CPA (inactive), is the Ernst & Young Professor of Accounting at the University of New Orleans, New Orleans, La.