Wednesday, March 15, 2023

On marking to market and risk management

Two more thoughts:

1) In the SBV debacle, many of my colleagues and friends jump to the conclusion, we should just mark all assets to market and forget about this "hold to maturity" business.

Not so fast. Like all imperfect patches, there is some logic to it. Suppose you have a $100 payment that you have to make in 10 years. To cover that payment, you buy a $100 face value Treasury zero coupon bond. Done, zero risk. 

Now interest rates rise. The value of your asset has fallen in value! It's only worth, say, $90! Are you underwater? No, because when the time comes, you still will have exactly $100 to make the needed payment. 

You will quickly answer, well, mark both assets and liabilities to market. The $100 payment is now also worth $90, so marking both sides to market would reveal no change. But there is a lot of unneeded volatility here. And in most cases, the $100 payment is not tradeable on a market, while the $100 asset is. So now, you're going to be balancing marking to market vs. marking to model. Add the regulator's and many participant's distrust of market prices, which are always seemingly "illiquid," "distressed," in a state of "fire sale," "dysfunctional," and so forth. Add the pointlessness of it all. In this situation we all know that you can make the payment in 10 years. Lock it up and ignore it. Call the asset "hold to maturity." 

Of course, suppose the point of that asset is to make sure that depositors with $100 accounts can always get their money back by selling the asset. Well, now we have Silicon Valley Bank. 

Hence the imperfect fudge of current accounting and regulation rules. "Hold to maturity" assets don't get marked to market, and indeed there are penalties for selling them to meet current needs. Lots of "liquidity" and other rules are supposed to make sure there are adequate short run liabilities to stop a run. Those were of course completely absent in SBV's case -- a truly spectacular failure of elementary regulation. 

In short, mark to market makes sense to assess if a bank can make its payments and avoid failure tomorrow. Hold to maturity makes a bit of sense to assess if a bank can make its payments and avoid failure years from now, when both long term assets and long term liabilities come due. That is, if it survives that long. 

2) There is a lot of criticism of SBV bank management and board for being underinvested in risk management and over invested in lobbying, political connections, donations to politically popular causes, and so forth. Ex post, their choice of managerial investments looks brilliant! What brought in the millions to stem a run, I ask you? In today's highly political banking system, they made optimal choices. To an economist, many puzzling actions are just an optimal answer to a different question. 

Update: Ok, I went too far with that one. Management are out, shareholders wiped out. I'll stick with the idea that uninsured depositors did a great job of monitoring -- they monitored that the bank had the political chops to demand and get a bailout of uninsured depositors! 

From a correspondent: 

"It seems to me now that SVB was really a money market fund with the addition of a bit of equity and breaking all the SEC asset and liquidity rules that MMFs are subject to. " 

Or, it was really a mutual fund (money market funds with $1 values can't invest in long term bonds, long term bond funds must have floating NAV) that was violating rules on floating NAV! 


  1. Not to mention that marking everything to marked is probably way too costly

  2. re: " Lots of "liquidity" and other rules are supposed to make sure there are adequate short run liabilities to stop a run. Those were of course completely absent in SBV's case -- a truly spectacular failure of elementary regulation. "

    The run was reportedly $42+ billion in a day. It seems that requires liquidation of lots of assets including HTMs. Its unclear whether the rule should be setup to handle that as a standard case to protect against in the regulations is if it were to be expected often, or whether it should be treated as the rare event it should be. There needs to be some way to handle it: but its unclear if its having the assets to cover a run vs. some way to stop a run temporarily to allow time for HTM or whatever to be liquidated, or some emergency mechanisms to come into play that are designed in advance rather than ad hoc over a weekend after a crash as happened this time.

  3. " a truly spectacular failure of elementary regulation." and yet "To an economist, no action is really a mistake, it's just an optimal answer to a different question. " Ruminate on that for a while.

    1. No need to ruminate. It's pretty simple. Here's the question to the you are seeking to the answer John exposed: "should I point the finger at an extremely well connected bank and risk my career, or is there some justification on which I can give a green light and slide on by?"

  4. Of course, you can also just look at the bank's balance sheet and footnotes to see the market value of the HTM assets and evaluate the bank's risk and decide for yourself whether or not to hold uninsured deposits. It takes about 5 minutes to find this info starting from a Google search.

    Per you other post (so as not to double comment), businesses like Roku SHOULD be fiscally savvy and monitor the bank(s) they use. Being busy "running a business" INCLUDES being financially sophisticated. Anectdotally, I talked to accountants at several smaller businesses over the past few days and they pay attention to their level of uninsured deposits and take specific actions to reduce their exposure.

  5. "Lots of "liquidity" and other rules are supposed to make sure there are adequate short run liabilities to stop a run. Those were of course completely absent in SBV's case -- a truly spectacular failure of elementary regulation"

    Are you implying the liquidity regulations, namely related to the liquidity coverage ratio, were absent because of recent tailoring rules that made them no longer apply to smaller banks, or that all liquidity rules do not acknowledge duration risk and therefore are inadequate? I would agree with the latter. Even if SVB were subject to the LCR, they would have exceeded those requirements given the size of their "liquid" securities portfolio. The liquidity rules do not contemplate unrealized losses and that treasuries may not be able to be sold without a 15-20% loss.

  6. What I don't understand is:

    1) Many economists who balk at price controls for gasoline or food or many other goods and services believe that the price control of fixed value liabilities with floating value assets is somehow OK, or necessary.

    2) What does liquidity have to do with any of this? You can always sell assets at *some" price. This is the price that is relevant if depositors want to withdraw their money. The fact that you could get more if you waited and shopped around a bit seems irrelevant.

  7. re: #1) Totally agree about HTM.
    re: #2) Don't agree here. CEO's career is over. He's personally already facing lawsuits and he may face criminal charges.

    The people who made the big score - the surprise right choice - are the people who chose to risk their money in uninsured accounts for higher return. They got the reward but will not pay the penalty for that choice, and everyone else is compensating them.

    That's why they should take a haircut. It's not the bank executives and board that are getting bailed out. It's the tech startup gamblers.

    1. Well, Mr. Anonymous, many of those you call "tech startup gamblers" were actual companies whose staff are all busy working on their particular innovation while trusting the bank to store the money that was given to them by a venture capitalist. There is a real world outside of the money-sphere. That real world is what gives us good things in our lives. The attitude your are espousing is the reason why we can't have good things.

    2. Well, it is the bank executives and board of some others banks (we maybe never now how many or which ones), but to say "We are doing this to avoid contagion" and to say "We are bailing out the executives and shareholders of other banks" is to say, essentially the same.

    3. E5: The real world **is** the money sphere. 90% of startup firms will wind up in the penny stock graveyard and never turn a quarterly profit much less repay the startup capital. If you don't make money, you're toast. That's the game in startups and in business. That's the only game.

    4. The reason we can't have good things is that the federal government is taking over the economy, suffocating private businesses and individuals. We need to sharply cut federal spending.

  8. I am not sure if holding outsized Treasuries and Agency MBS is the key problem for SVB's failure.
    To see that, let us ask: would SVB have been better off, if it had all assets in loans? Not at all. Loans are less liquid, and also subject to interest rate risk. People can make jokes about the "unrealized losses" on the investment securities that banks hold, but loans have "unrealized losses" too, and potentially much bigger.

  9. The synonym for 'mark to market' is 'fair value'.

    US GAAP classifies investments in debt securities under the following headings:

    1. Held-to-maturity securities ("HTM securities")
    --> intent and ability to hold until maturity

    2. No intent or ability to hold until maturity
    --> classified as either (a) or (b)
    (a) trading securities
    (b) available for sale securities ("AFS securities")

    The valuation method applied to each of the US GAAP classifications is
    listed under "Measurement of Investments in Securities":
    1. Trading Securities: Fair Value (a.k.a., "mark to market")
    2. AFS Securities: Fair Value
    3. HTM Securities: Amortized Cost

    How should changes in fair value be reflected in the firm's financial reporting?
    Changes in Fair Value:
    (I) Unrealized holding gains or losses --
    1. Trading Securities: recognized in earnings;
    2. AFS Securities: recognized in "Other Comprehensive Income", not in earnings;
    3. HTM Securities: not recognized

    (II) Impairment of AFS and HTM securities:
    If the decline in fair value is "other than temporary" recognize impairment losses in earnings.

    [Source: ]

    It would be a fair guess that at the time KPMG was preparing its report and letter of opinion on SIVB's financial statements for the year ended 12/31/2022, discussion with SIVB senior management concerning the status of those "held to maturity" T-notes and MBS financial assets was both lively and pointed. Management no doubt argued strenuously for the status quo; the auditor argued the contrary -- recognition of impairment "other than temporary" and reclass of the "held to maturity" to "available for sale" and a charge to earnings reflecting the impairment of the SIVB's "ability to hold until maturity” and the change in "fair value" of those securities.

    Management's point of view was informed by concern over the requirement for a certain minimum threshold of regulatory capital that reclassification of HTM debt investments to AFS debt investments because of the impairment charge necessitated under US GAAP, almost surely. By not recognizing the permanent impairment of HTM debt investments, SIVB granted itself time to search for outside sources of liquidity. The count-down clock ran out at midnight on the 9th of March.

    Would a ‘mark-to-market’ stipulation have staved off SIVB’s insolvency? Or, changed management’s behavior? By 12/31/2022, SIVB’s regulatory capital was gone, for all intents and purposes. It wasn’t insolvent as at 12/31/2022, but except for the classification of a majority of its T-note and MBS investment holding as “held to maturity” it was effectively bankrupt.

    Classification of those investments as “available for sale” under the fair value doctrine (‘mark to market’) would have forced the issue of regulatory capital adequacy during 2022 and impelled SIVB management, under regulatory pressure, to change course.

    It is not a question of changing or eliminating the “held to maturity” classification under US GAAP, but the proper evaluation of the firm’s “intent and ability to hold until maturity” those debt securities that it classifies as “held to maturity” on its book of accounts and in its financial statement reports. Clearly, this is an area that requires more regulatory oversight, as John correctly points out above.

    1. SIVB's 10-Q from Q3/2022 already showed effective insolvency in footnote for HTM securities. Why the 7-8 month delay in regulators' dealing with it?

    2. We should have a better idea when the FDIC and Federal Reserve Board of Directors report their findings in the month of May.

  10. In this case we had a stylized example with the liabilities and assets having the exact payoff after every time period ($100 after 10 yrs) so it was easy to cancel them out and say "ignore it and hold too maturity". In reality that would never be the case. Would a rule minimizing duration mismatches or the like be helpful then?

  11. I see two similarities to the 1997 Asian financial crisis. Duration mismatch between assets and liabiliies and crony capitalism.

  12. In the absence of some prudent bank treasury management via hedging activities, match funding would substantially address the issue of interest rate risk. If no steps are taken to rectify an issue of unrealized losses in bank portfolios such as the foregoing, then it would seem to make sense that if losses exceed some % of capital for some time period that the bank would have to raise capital.

  13. The claim that recognizing the inherent variability of assets and liabilities from changing realities (and prices) is "unneeded volatility" strikes me as a the most uneconomic of complaints coming from an economist. Life is volatile. The inconvenience of reality does not absolve one from the obligation to grapple with it. While it is selective and misleading to subject one piece of one side of the balance sheet to market discipline, that fact should not be used to impugn appropriate and rigorous financial analysis of all balance sheet risks. Sticking your head in the sand is not a recipe for success in financial risk management.

    It is absolutely correct to say that once a run begins no amount of MTM or liquidity or capital (short of 100%!) will stop it. But that is not the right question. The right question is - how did we get to the precipice of the run? How did that happen? Had SVB analyzed and disclosed the full market impact of rising interest rates (on BOTH assets and liabilities) one year ago the drip, drip, drip of bad news would have likely forced a corrective action before it was too late.


  14. Regarding SVB's underinvestment in risk management and overinvestment in lobbying, the result of zero dollars for shareholders and protection for depositors is not a good outcome for a company to achieve. The board and management should be maximizing the return for the shareholders, not for the customers.

    1. Anonymous at 11:21am; what makes you think SVB was in any way trying to maximise return for customers? It seems that they were trying to maximise return for managers and overdid it.

  15. John, I get your example in point 1. I respectfully disagree. The CBOT was founded in 1848. The CME has been operating since 1926. The Options Clearing Corp was founded in 1973. They have never, in those time intervals, been bankrupted because a basic risk management rule applies. All positions are marked to market at the close of every business day. On any given trading day, if value of your portfolio declines, mark to market, that amount comes out of your account. If your account value falls below the maintenance margin, you'll be required to deposit more cash into your account or liquidate your position. When bonds in the banks portfolio were at a premium, did they reflect the unrealized market gain or carry them at par? Either way in this scenario, bonds are improperly priced relative to real time market prices. In the end, it isn't surprising banking execs take excessive risk because they believe there is a Fed put, ala Greenspan and Bernanke, that will socialize those losses.

    1. "When bonds in the banks portfolio were at a premium, did they reflect the unrealized market gain or carry them at par?"

      For available-for-sale securities, the change in fair value (cf., "mark to market") is recognized in comprehensive income unless the change results in an impairment that is "other than temporary" when it then is charged to income in the period.

      For held-to-maturity securities, the change in fair value is reflected in the balance sheet, but otherwise is not recorded in the book value of the securities unless the change results in an impairment that is "other than temporary" when the change is then charged to income in the period it is recognized in.

      "Either way in this scenario, bonds are improperly priced relative to real time market prices."

      It is important to distinguish between your trading account at a brokerage, and the assets that are held in a state- or federally-chartered bank as "available-for-sale" and "held-to-maturity". The financial markets in bonds and notes and mortgage backed securities are over-the-counter and in many instances there is no active market for the securities and therefore no "market price". FHLB bonds for example were not quoted yesterday on Fidelity Investments brokerage website, and nor were Federal Farm Credit Bank bonds, both rated AAA.

      Additionally, it is important to note that the bank financial statements published quarterly and annually reflect a 'snapshot' of the bank's financial condition at a specific point in time, whereas your trading account balances are viewable in "real-time" (whatever that may be) and even so, if a security has no quoted price, the brokerage firm's pricing algorithms produces a 'market price' to display and value your holding in that security (whatever it is). And, prices, whatever they are, are ephemeral -- here for the moment, a heart-beat in length, then gone, replaced by another price or, maybe, nothing at all.

      "Fair value" is the appropriate term to use with "available-for-sale" and "held-to-maturity" securities. Securities held for trading are always, everywhere, 'marked to market' even when no market for the securities exists. The distinction has important economic and legal implications.

    2. Eagle Eye, Thank you for the explanation. You wrote "Fair value" is the appropriate term to use with "available-for-sale" and "held-to-maturity" securities. Securities held for trading are always, everywhere, 'marked to market' even when no market for the securities exists. The distinction has important economic and legal implications." It certainly does. Credit Suisse, SVB and other regional failures are examples writ large. Cochrane tells us the pricing of all assets is grounded in one simple measure. "Current" price equals expected discounted payoff that reflects the macro-economic risks underlying each security's value via a single stochastic discount factor. Modern asset pricing in it's most fundamental form. Some attention by a competent risk manager to the basics of this fundamental principle, bond convexity and duration risk might have precluded the SVB, CS debacles. I'm a risk manager with forty years experience in various hedge funds. When a trader asked about taking a position in an instrument, my first question as a fiduciary, "What's the most we can lose on this trade?" The second question, "What's the most we can profit?"

    3. John's description of the price of a financial asset (or, liability) is a short-hand way of describing the fundamental theorem of asset pricing. The price obtained by application of that theorem is called the 'fair value' of the asset (or, liability). Market transaction price(s) differ from the 'fair value' obtained via the theorem for a number of good and valid reasons (collectively referred to as "market frictions").

      If there are parallels between SIVB and CS, and that would be tenuous at best if at all, then at its root it rests on management behavior and incentives and the prior business experience of the CEOs and other senior executives who steered policy in their respective banks.

      In SIVB's case, the maturity mismatch between financial assets and financial liabilities (esp., investment portfolio assets vs. demand deposits and the growth of the latter), required no sophisticated concepts to grasp -- simple arithmetic suffices.

      In CS's case, the trouble was in a business model that was no longer competitive in the NY financial market against larger U.S. and foreign banks.

      Both banks will make for compelling graduate business school cases along several dimensions, esp., organizational behavior (senior exec., board of directors, etc.), and corporate policy.

  16. can you write a story about technical analysis for us. Is it worling?

  17. It is worth nothing that major changes in mark-to-market accounting in GAAP were launched in the fall of 2007 with 2008 as the immediate consequence.
    It strikes me that the regulatory structure and the GAAP treatments may be out of synch due to different purposes, goals and time of origin.
    That said, rules are rules. The fact that SVB went long 30 yr MBS in an environment of clearly increasing rates was an inexplicable error. It is rumored that SVB did not have a functioning risk management operation. While I do not know what is the case in that regard, the structure of the trades and the source of funds (non-interest bearing demand deposits) screams of management failure of the most elementary flavor.

  18. Hi John—would be interested to hear your thoughts on Hal Scott’s editorial in today’s WSJ:

  19. I think the HTM accounting makes much more sense as it relates to a mark to market loss in terms of a widening of credit spreads.

    Not at all in terms of an increase in the general level of interest rates.

    If you have an increase in the general level of rates, presumably you will have to increase the rates you are paying out as well (which is starting to happen now), so even though you're not recognizing the loss on a MtM basis you will be recognizing it on a negative net interest margin basis year by year. Which would not happen if the loss was due to spread widening.

    In essence you're a zombie bank

  20. This comment has been removed by the author.

  21. I always enjoy reading your posts, thank you for sharing your knowledge with us.

    I think the problem with your example is that banks are not holding those bonds to maturity only to have the money for depositors. Instead, many of them are using those bonds as leverage and then lending out additional money to some funds that take a lot more risk in the markets. When those risky funds go belly up and the bank wants their money back, the funds don't have it and the bank is now on the hook.

  22. Just listened to Kevon O'Leary of Sharktank fame on Tucker Carlson. He says many medium and large companies are now getting out of all their regional bank relationships and sending the monies to the too big to fail banks: JP Morgan, Citicorp, Wells Fargo etc.

    Similarly investment accounts brokerages are seeing a massive selling of regular Money Market Funds and that money is all going into US treasury MMF's. $16 billion last week.

    O'Leary believes that regional banks are done for because they are now to be bailed out 100% so there is no incentive NOT to gamble with depositors money to keep the depositors there.

    I bank in other countries like Canada that has 5 big banks and that is about it. O'Leary says that is exactly where we are headed. Carlson then said but the US Government will now have much more control over you wealth and banking. O'Leary basically said, "Well, tough."

  23. Well, it's just asset liability matching, right? It's just that the maturity on deposits is a big unknown. Normally, it's fairly predictable and you can match a big chunk to longer term securities. But, you have to be prepared for the possibility of things not being normal. So, maybe the solution is just to require banks have enough short-term securities to cover all their deposits, i.e. narrow banking? I'm sure people will exclaim how inefficient that is during normal times, but I say, "meh". Put a little more onus on savers to think about when they need access to their cash. For crying out loud, if tech startups can't have reasonably competent treasury employees, then the VCs that fund them deserve the losses they face. Seriously, Roku couldn't manage their own ladder of Treasuries?

    And, btw, SIVBs portfolio was virtually 100% MBS and CLO ... far worse than Treasuries because duration extends as interest rates go up.

  24. The $100 asset earns 2% over the next 10 years but they have to pay 5% to depositors now to fund it. That isn't a temporary market to market problem, its losing 3% a year.

  25. Failure in regulatory agencies is now a pre-text for expanding the regulatory state into more corners of the financial market. Money market funds, hedge funds, and 'stable coin' purveyors, along with regional banks that have $100 billion or more in assets, will now see increased federal authority oversight and restrictions on their operations in the name of increasing the stability and reducing the risk of the U.S. financial system. Secretary of the Treasury, J. Yellen, is reported to be supportive of expanding the scope and the powers of the federal regulatory bodies in order to prevent repeat of the failures of SVB and Signature Bank, &c.

    During the Obama administration, the tag "systemically important" was applied to the likes of GE and Prudential in an effort to regulate the non-bank financial sector. One of the consequences arising from this innovation was the divestment of GE's divisions and the shrinking of insurance companies in order to bring those corporations' size below the threshold set for "systemically important" non-bank financial firms.

    A similar result will be seen in the current mid-size banking sector. If the "systemically important" asset size threshold is set at $100 billions, as currently it is expected it will be, then mid-size banks with assets in excess of $100 billions will divest themselves of assets in order bring their operations under the asset size threshold that triggers increased federal regulatory supervision. The U.S. banking industry will then see a bi-modal distribution of bank sizes -- the under-$100 billions asset class, and the over-$250 billions asset class--with the regional banks in the former class and the money-center banks in the latter class.

    Similar changes in regulatory oversight of non-bank financial firms (money market funds, hedge funds, &c.) will see those financial industry segments segregating into small size firms and large size firms, with the former adapting the size of their operations to avoid regulation while the latter will adapt to increase the size of their operations at the same time as they adopt more conservative investment policies to fit within the 'safe' harbors that the regulators define.

    It is well to note that SIVB's investment criteria avoided risky loans while embracing low-risk federal agency-issued mortgage-backed securities to meet its net interest income targets. This was, in part, the bank holding company's policy response to federal regulations designed to avoid the supposed root-cause of the 2007-2008 financial crises, according to ‘Dodd-Frank’.

    As the regulatory state expands, the actors that come under enhanced regulation adapt. Adaptation takes several forms, of which avoidance of regulatory oversight is one such form while avoidance of regulatory-deemed risky investments is another such form. This is predictable ‘economic actor’ behavior.

    Depending on the scope and constraints to be imposed on the non-bank financial sectors in the U.S. financial system, we should expect to see multiple adaptations ranging from the closing of firms to the change in size of firms and the change in operating policies of firms. Whether that addresses the 'risk' that the Administration sees in today's non-bank financial sectors or not, is beside the point — the regulators’ regulator has determined that an anticipatory response is needed. What could possibly go wrong?

  26. I havent' read all the comments, but they seem to miss the point. True, the SVB management may have just been stupid and not realized the risk they were taking. But their behavior could have been ex ante optimal. They were using government deposit insurance to gamble on interest rates. The gamble was at market prices, so it was a fair gamble. If they'd won, SVB shareholders get all the benefit. If they lost, limited liability means the government takes the hit, even without the special bailout they got.

    This strategy should be constantly in the mind of a smart bank board of directors. The entire job of the bank regulators is to thwart it by not allowing the bank to take on so much risk. They utterly failed, and should all be fired, since one analyst could have done their job better single-handedly if he was allowed to see the balance sheet, regardless of the accounting method.

  27. Still a little baffled by the continuing focus on accounting rules. We had other banks failing in the same time frame with less obvious accounting mistreatments.

    The underlying issue is that there are few barriers to entry in banking. A dollar is the same whichever bank is lend it from or deposit it with. We have seen in every banking crisis that the fastest growing banks at the end of the cycle are the most likely to experience difficulties. We have academic papers analysing it. And it does not matter if the growth was driven by the asset-side or the liability-side. Economically, fast growing banks accumulate the worst (flightiest, riskiest) customers at the margin.

    As a result, I think the correct regulatory response is to include deposit growth as a determinant of counter-cyclical buffers.


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