Accounting for Bank Failure

Could better accounting rules have saved Silicon Valley Bank (SVB)? The answer is a resounding maybe.

On the one hand, fair-value accounting for securities would have caused SVB to recognize its losses earlier and, perhaps, to have avoided those losses in the first place. On the other hand, greater accounting transparency can unnecessarily cause bank depositors to panic at the first sign of trouble, threatening the stability of the banking system.

Because of these conflicting effects, any change to accounting rules that causes banks to record securities or other assets at fair market value has to be accompanied by more fundamental reforms that limit depositor incentives to panic, such as enhanced deposit insurance.

As is now familiar, SVB was done in by a fall in the value of its bond portfolio, which made up 55% of its total assets at the end of 2022. When tech investment dried up, SVB’s business customers spent down their cash. The resulting deposit withdrawals forced SVB to sell its bonds at a loss. Depositors’ fear of further losses resulted in a classic run on SVB.

What does all this have to do with accounting? According to the Financial Accounting Standards Board (FASB), banks may designate securities that they do not intend to sell in the near term as Available for Sale (AFS) or Held to Maturity (HTM). If a security is designated as AFS, then it is recorded on the bank’s balance sheet at its fair market value. Unrealized changes in the security’s market value are recorded as a part of shareholder equity, but they are excluded from earnings on the income statement.

SVB’s losses on its AFS holdings were enough to signal a potential issue with the bank. SVB held $26 billion in AFS securities at the end of 2022, and it reported $2.5 billion in unrealized losses from these securities. These losses amounted to 15% of SVB’s total equity at the time, enough to merit the attention of all of SVB’s stakeholders.

But that was just the tip of the iceberg. SVB also held a sizable $91 billion in HTM securities, 43% of its total assets. HTM securities are securities a bank intends to hold to maturity rather than sell. They are recorded on the balance sheet at cost and their value is adjusted over time according to a fixed schedule. Importantly, unrealized gains or losses in HTM securities due to market fluctuations are not reported as income, though they are recorded as notes to the financial statement.

By the end of 2022, SVB was more or less a zombie bank on a fair market value basis. SVB’s HTM securities had experienced $15 billion in unrealized losses, just over 90% of SVB’s total equity. Still, both SVB’s management and shareholders appeared to believe that they could manage any short-term losses until their bonds eventually matured and rose in value.

Suppose SVB was unable to classify $91 billion in securities as HTM in an attempt to hide its financial position from the public. With fair-value accounting, SVB would have had to instead recognize $15 billion in unrealized losses on its income statement over the course of 2022. This would surely have been noticed by its shareholders, depositors, and the financial press.

Of course, fair-value accounting isn’t that beneficial if it just pushes bank failures back by a few months. A change in accounting rules has value for banking regulation if it would have caused SVB’s behavior to change, for example, by hedging its interest-rate risk with swaps, or by not accumulating so much interest rate risk in the first place.

We cannot know with certainty whether SVB would have changed its behavior if it knew the value of its bonds would be transparently reflected in its financial statements. But it is reasonable to believe that greater accounting transparency leads to better incentives to manage risk and to advocate for it whenever possible.

Fair-value accounting could also have a salutary effect on bank regulators. Regulators have strong incentives to delay action in the hope that a troubled bank will heal itself, a dynamic that was likely at play between the SF Fed and SVB. Greater accounting transparency could spur regulators to swifter and more decisive action. For example, the financial press would certainly have asked questions if SVB recognized $15 billion in losses in 2022 and the Federal Reserve took no action.

Unfortunately, unlike the case of nonfinancial firms—where it is reasonable to assume that accounting transparency is an unmitigated good—in the case of banking, transparency also comes with costs. Banking scholars have long argued that there is an optimal level of opacity in banking.

Fair-value accounting could spook depositors into thinking a bank is insolvent when it is not. For example, SVB’s bond portfolio would eventually have regained its value as the bonds matured. If deposit withdrawals had continued in their normal course rather than accelerating out of fear, SVB may well have been able to manage its earnings and remain solvent and a national banking emergency averted. Therefore, fair-value accounting could encourage bank instability by causing depositors to panic at the first sign of financial distress.

Unfortunately, the contradictory effects of accounting transparency cannot be resolved without additional reforms. The transparency and incentives benefits of fair-value accounting—for banks and regulators alike—are sound in theory and proven in practice. But given its effects on depositor incentives, accounting transparency is not worth the candle unless it is accompanied by increased insurance for depositors, who may rush for the exit if they don’t like what they see.