Book Value Risk Management of Banks: Limited Hedging, HTM Accounting, and Rising Interest Rates

We document that faced with 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 risk of asset market value declines, banks used accounting reclassification to diminish the impact of interest rate increases on their 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, particularly those supervised by less stringent state regulators, were more likely to reclassify. We use a simple model to study the interaction between capital regulation, accounting rules and incentives to recapitalize banks following interest rate increases. We show that capital regulation can help mitigate run risk, as bank equity holders may be hesitant to address this risk by recapitalizing or insuring a portion of their assets against interest rate fluctuations. The use of HTM leads strong banks to ameliorate deadweight costs from capital requirements that are too tight, but critically allows weak banks to window dress capital requirements and remain exposed to runs. Including deposit franchise value in regulatory capital calculations without considering run risk could weaken capital regulation’s ability to prevent runs. Our findings have implications for regulatory capital accounting and risk management practices in the banking sector.