The world of banking and finance can be quite complex and difficult to understand. Recently, there has been a lot of discussion about banks and their accounting practices, particularly with regards to their bond portfolio management. It can be confusing to differentiate between Held-to-maturity (HTM) and Available-for-sale (AFS) bond portfolios but allow me to help clarify some of these issues.
Banks invest in bonds as a way to generate profits. To hold these bonds, banks have two options: "hold to maturity" (HTM) and "available for sale" (AFS). The decision on which method to use depends on their investment goals, with some seeking steady, long-term returns, while others opt for quick profits from market changes.
When banks hold HTM bonds, they do not have to worry about how the market value of those bonds’ changes over time. That’s because the banks’ plan on keeping those bonds until they mature. So instead of recording the daily changes in the values of those bonds, the banks simply report the original purchase price of the bond, known as "amortized cost." The idea is that since banks hold HTM bonds until maturity, the market value doesn't matter until the bond matures.
On the other hand, AFS bonds are reported differently. These are bonds that the Banks report the fair market value of daily. This means they're subject to change based on how the market is doing. If the value of an AFS bond drops, the bank might take a loss on the bond. If the value of an AFS bond goes up, the bank might take a profit. This is also the bucket where most of a banks liquidity needs come from.
The bond portfolio methods that banks use have a significant impact on their capitalization, as they rely on a metric called "risk-weighted assets" (RWAs) to determine their capital requirements. RWAs are calculated by assessing the riskiness of a bank's assets, with riskier assets requiring banks to hold more capital. The type of bond portfolio a bank chooses to employ directly affects how RWAs are calculated.
HTM bonds are seen as less risky because banks hold them to maturity, which means that their market value is less volatile. As a result, banks holding HTM bonds can calculate RWAs based on the purchase price of the bond, rather than the market value. This means that HTM bonds have less impact on a bank's capitalization.
AFS bonds, on the other hand, are considered riskier because their market values can change. RWAs for AFS bonds are calculated based on the current market value, which means that AFS bonds can have a bigger impact on a bank's capitalization. If the market value of an AFS bond drops, the bank might need to hold more capital to cover potential losses.
Unfortunately, there can be unexpected events that can severely impact banks' capitalization, such as a sudden rise in interest rates. For example, in March of last year, the Federal Reserve's target rate was 0-0.25%. Today, the target range is 4.75-5%, which is a steep move in interest rates over just one year. Bond portfolios took serious losses, and any bank that had or may have to sell their bonds in their HTM account will be in a tough situation. They would be forced to realize large losses on bonds that they never intended to sell and possibly affect their capitalization. This is what happened to Silicon Valley Bank and a few other regional banks. If inflation remains stubbornly high, forcing the Fed to raise rates, a few more banks may be caught up in this situation.
In conclusion, understanding the differences between HTM and AFS bond portfolios is crucial for comprehending how banks invest and how their capitalization is affected. HTM bonds are seen as less risky and have less impact on bank capitalization, while AFS bonds are considered riskier and have a greater impact on bank capitalization. Even with careful portfolio management, unexpected events can cause significant losses for banks. It is essential for banks and investors to monitor their investments closely and be prepared for potential losses.
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