Professional Advice: Rules of engagement

As banks grapple with bond losses, new research suggests they will comply with accounting rules but break classic investing rules

Jeffrey Burks
Jeffrey Burks

As banks, such as the recently collapsed SVB Financial Group, grapple with bond losses, new research from the University of Notre Dame suggests they will try to limit the effect on earnings and regulatory capital by following accounting rules to the letter.

Yet in doing so, they will violate a core tenet of standard investment theory by looking backward at investment performance rather than forward, according to the book, “Why Do Banks Gain and Loss Sell Securities,” which I co-wrote with John Aland of Fairfield University.

For the vast majority of bonds held by a typical bank, accounting and regulatory capital rules don’t count bond losses against earnings and regulatory capital until the bonds are sold. Another accounting rule, known as the other-than-temporary-impairment (OTTI) rule, also penalizes selling bonds at a loss.

The way the rule is enforced, selling some bonds at losses could force the bank to immediately recognize additional losses in earnings and regulatory capital on its other bonds that it did not sell. Effectively, loss selling some bonds casts doubt on the bank’s ability hold its other bonds until they recover in value, which triggers additional charges to earnings, an effect referred to as “tainting.”

These rules give banks incentive to be backward-looking in their selling decisions, holding on to past losers and selling past winners. In contrast, standard investing theory says to look forward and choose which bonds to sell based on where the bank thinks the value is headed, which is not necessarily indicated by the bond’s past movements.

The study shows banks indeed look backward when choosing which bonds to sell, holding onto past losers and selling past winners. In an average quarter, the study finds that for every dollar of unrealized losses from past losers that are sitting in the bond portfolio, a bank tends to sell off 2 cents of the losses.

In contrast, banks tend to sell off 3 cents of each dollar of unrealized gains from past winners, representing a 50 percent higher tendency to sell past winners as compared to past losers.

The study also finds that banks work hard to offset losses on sale with additional gains on sale, but not vice versa. It shows that for every additional dollar of losses from a bond sale, banks tend to sell winners to generate additional gains of $0.70 to $1.47, hence covering up most or all of the losses on a net basis.

In contrast, banks seem fine with leaving gains uncovered. They tend to offset an additional dollar of gain selling with only 12 to 17 cents of loss selling.

These games that banks play with offsetting again have little to do with identifying the best securities to sell from a valuation or liquidity perspective.

With the large proportion of bonds that are in loss positions right now, banks may not be able to insulate earnings and regulatory capital using the avoidance tactics that they have in the past. They may have to sell bonds that are in loss positions. On the other hand, there is perhaps more incentive than ever not to do this because of the OTTI rule. Banks don’t want to taint their portfolios and then have to record losses on the remaining unsold bonds as well. The tainting fear is a strong incentive not to loss sell in the first place. It’s a tug-of-war between fundamental economic pressures to sell and accounting rules that discourage loss selling.

This article originally was posted on the Notre Dame website.


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