The SVB Collapse: FASB Should Eliminate “Hide-‘Til-Maturity” Accounting

“The purpose of financial reporting is to convey the results of the company. It is not to assure the company stays around.”

That’s what I told Floyd Norris in the 2009 New York Times piece, “Confronting High Risks and Banks.”

The Silicon Valley Bank (SVB) collapse recalls the tussle over the accounting for financial instruments after the global financial crisis (GFC) in 2009, particularly the debate about whether some financial instruments should be carried at amortized cost (held-to-maturity, HTM) rather than at fair value (available-for-sale, AFS), or what is referred to as the “mixed measurement model.” 

The Post-GFC Financial Instrument Debate

The Financial Accounting Standards Board (FASB)’s 2010 financial instruments proposal suggested that accounting for many financial instruments (including loans) should be at fair value. We commented on that 2010 proposal, noting our support for fair value of financial instruments and our opposition to the “mixed measurement model.” The excerpt below summarizes why some support the mixed measurement approach and why CFA Institute supported a fair value model. We included an appendix to that letter explaining in detail why fair value was a better measurement method.

Then-FASB chair Bob Herz understood the economics of financial instruments and how they should be reflected in financial statements, and he rightly advocated for a fair value approach. He recognized that masking fair value with a mixed measurement model, which allows some financial instruments to be reflected at their historical cost, only hides the impact of market risks on a bank’s financial stability and valuation.

Under political pressure, the FASB retreated from its initial 2010 proposal and Herz, unfortunately, resigned. The FASB then went on to retain the “mixed measurement model” wherein securities can be classified as held-to-maturity based upon “management intent” and “business model/strategy.”

What that means is that the financial statement carrying value of those financial instruments held-to-maturity is reflected at amortized cost, or what management paid for the asset sometime in the past plus amortization of the discount or premium from the face value. The fair value is only disclosed on the face of the financial statement and in the footnotes. Any unrealized loss is “hidden in plain sight.”

But management intent and business model do not change the value of financial instruments. The HTM classification only makes it harder for investors and depositors to see. 

SVB’s Balance Sheet and HTM Portfolio

This is what SVB did. At 12/31/2022, SVB reflected $91.3 billion of HTM financial instruments, 43.1% of its balance sheet, at amortized cost. Their fair value was only $76.2 billion, or $15.1 billion less than their carrying value. With only $16.3 billion in book equity, this loss would have reduced equity, assuming the losses had no tax benefit, to $1.2 billion. Even with a tax benefit — if SVB could recoup all the tax benefit — this would amount to a $11.9 billion reduction in book equity. (See balance sheet below.)

Interestingly, SVB also had $74.3 billion of loans (net of $0.6 billion of accrued credit losses under the cumulative expected credit loss model), or 35.1% of its total assets at amortized cost. The fair value of those loans, as explained in Note 22 to SVB’s financials, was above fair value at $74.6 billion, because, as described elsewhere, most of the loans are variable rate. 

Overall, SVB’s total assets at 12/31/2022 were $211.8 billion of which only approximately $40 billion (cash and available-for-sale (AFS) securities) were at fair value and immediately available to pay the $173 billion in deposit liabilities — which are all due within the next year, according to SVB’s contractual obligations table. 

Sales of the HTM securities would “taint” the portfolio and trigger fair value accounting. Said differently, the $15.5 billion unrealized loss would be recognized in the financial statements. The accounting effectively discourages management from making sales it may need to make to meet deposit commitments. Together, the cash, AFS, and HTM securities had a fair value of $115 billion, or 67% of the bank’s deposit liabilities at 12/31/2022.

This increase in unrealized losses emerged during 2022 with the rise in interest rates, but we didn’t first learn of it last week or when the 12/31/2022 financial statement was issued just a few days earlier in late February. At 9/30/22, the unrealized loss on the HTM securities was $15.9 billion — actually more than at 12/31/2022. So, there was a clue; it just wasn’t very obvious. 

The Focus on Net Interest Margin (NIM) Rather Than the Fair Value Balance Sheet in Periods of Market Volatility

What makes things more challenging for investors and depositors is that amortized cost accounting — as we saw in the lead-up to the GFC — focuses banks and their investors and depositors on net interest margin (NIM). The problem with NIM is that it too is very static and focuses financial statement readers on the past rather than the present or the future, as is the case with the fair value of assets. NIM can look good while the market value of the assets on the balance sheet implodes. 

Asset Liability Management and Cash Flow Characteristics of Financial Instruments

Further, the disclosures inside and outside the financial statements don’t give investors sufficient insight into the asset liability management (ALM) of the bank. In the case of SVB, investors and depositors didn’t have insight into the concentration of the deposits, their connection to the loans, or how fast they could flee given that concentration (i.e., other than the disclosure in the contractual obligations table which said everything is due immediately). Insurance companies are lucky as withdrawals happen more slowly. Policyholders have to die, become disabled, or pay extensive surrender charges to get their money back. Banks customers just need to log on and transfer the funds.

Circa 2012, the FASB also considered disclosures of the cash flow characteristics of financial instruments. The SEC pushed back on that, saying “financial analysis should not be done in financial statements.” The problem is the SEC never acted to provide better disclosures on ALM management for investors. Now might offer the opportunity to correct that. 

A Run on the Bank Can’t Be Anticipated, Or Can It?

So, while some argue the SVB bank run couldn’t be predicted, the unrealized losses were there for investors and depositors to understand. It just required some digging. This is why, as we noted in the appendix to that 2010 FASB letter, “highly relevant information” belongs in the measurement of financial instruments in the financial statements not simply in the disclosures. 

Sophisticated investors adjust the value of a bank’s balance sheet for fair values, and in periods of stress, more attention should be paid to the balance sheet and cash flows.

HTM only delays the recognition of these realities and — as I noted in the above 2009 quote — helps investors see the value of the company rather than ensure it stays around because of an inability to discern the real economics. Hence, held-to-maturity becomes hide-until-maturity — until the jig is up and an SVB-style bank run breaks out.

Essentially, SVB’s “mid quarter update,” last Wednesday — when management advised investors and depositors that they had sold nearly all of their AFS securities — hastened the race to the exit, just as interest rates peaked. Maybe SVB should have sold its HTM securities as well. 

The Fed Raised Rates and All HTM Securities Losses Were Masked

Short-term interest rates have risen steadily over the last year as the US Federal Reserve moved borrowing rates from near zero to nearly 5% last week. Many financial institutions have sizeable unrealized losses on these HTM securities tucked away in the footnotes to financial statements. Depository institutions (SIC 6000) with large unrealized losses on HTM securities, as a percentage of their equity, as of their latest SEC filing, raises questions.

The Fed’s own actions should have alerted banking regulators to the emergence of such losses and their impact on bank business models. Unfortunately, the information in the financial statements was not as obvious as it needed to be. This should have been predictable since the value of fixed instruments always declines when rates rise. Even SVB’s financial statements showed significant unrealized losses back in September. It seems SVB’s “mid-quarter update” last Wednesday alerted SVB’s customers and they headed for the exit, or the computer. 

FASB Needs to Act to Eliminate Held-to-Maturity and the Mixed Measurement Model

We believe the FASB needs to eliminate the HTM classification to reflect all financial instruments properly at fair value in the financial statements. Further, we believe the FASB and SEC need to work together to provide greater transparency into bank business models and the cash flow characteristics of financial instruments (both assets and liabilities). The puzzle is too complicated for depositors to piece together from a 200-page set of financial statements. Depositors understood the implication of “mid quarter update” when SVB said it had moved all its saleable assets to cash. The news spread among its depositors, resulting in a $42-billion run on cash. 

A reminder from the SEC might be a good idea right now as the first quarter of 2023 approaches its close. 

The good news — or bad news — today is that the two-year Treasury has dropped 100 bps from 5% last Wednesday to 4% this morning. So those financial instruments are less underwater.

For more insights from Sandy Peters, CPA, CFA, check out “The Audit Gender Gap: Has It Narrowed?”

If you liked this post, don’t forget to subscribe to Market Integrity Insights.

---

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Image credit: ©Getty Images/ RapidEye

---

Professional Learning for CFA Institute Members

CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Market Integrity Insights. Members can record credits easily using their online PL tracker.