One problem with current GAAP (Generally Accepted Accounting Principles) is that banks can hide interest rate risk.
Following the 2008 Great Financial Crisis, accounting standard setters got strict about credit risk, but as Silicon Valley Bank demonstrated, it’s possible to have investments with substantially no credit risk whose prices move around a lot when interest rates rise.
Those price movements don’t, in theory, matter if the bank plans to hold those investments (assuming they’re bonds, which they usually are) until maturity. But what if the bank can’t?
As SVB demonstrated, that’s when things get ugly.
Associate Professor of Accounting Joao Granja, from the University of Chicago’s Booth School of Business, recently published a paper called Bank Fragility and Reclassification of Securities into HTM.
Joao found that the weakest banks – those most vulnerable to a bank run – made the most liberal use of “held-to-maturity” accounting, which is based on historical cost, rather than market value.
On the other hand, valuing those bonds at market values would inject a lot of price volatility into bank financials – volatility that’s probably irrelevant most of the time.
Despite my spotty intro, Joao is spot-on. We talk about problems and solutions to the FASB’s dilemma. Watch below.