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. Instead of hedging against the risk of asset market value declines, banks used the held-to-maturity (HTM) accounting to reduce the impact of rising interest rates on their book capital, reclassifying an additional $1 trillion in securities as HTM as rates began to rise. More vulnerable banks, particularly those supervised by less stringent state regulators, were more likely to use HTM classification. We use a simple model to study the interaction between capital regulation, accounting rules and incentives to hedge asset interest rate risk or recapitalize banks. Capital regulation can help mitigate run risk, especially when bank equity holders are reluctant to address it through hedging or recapitalization. While HTM accounting can allow strong banks to avoid the deadweight costs of overly tight capital requirements, it also enables weaker banks to window-dress their capital positions leaving them vulnerable 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.