Photographer: Andrew Harrer/Bloomberg

How Banks Are Using Accounting Shifts to Prepare for an Interest Rate Rise

Choose your own accounting, U.S. banks edition

You are a large bank with a multibillion dollar portfolio of securities, ranging from municipal bonds to U.S. Treasuries and mortgage debt backed by the government.

For years, you were able to classify those securities as either available-for-sale (AFS) or held-to-maturity (HTM). If the market value of the securities moved, you didn't have to worry too much unless you crystallized your paper gains or losses by actually selling the securities. So-called unrealized gains and losses on AFS holdings were excluded from net income and counted only toward shareholder equity under generally accepted accounting principles. That began to change in 2013, thanks to new banking regulations. Any mark-to-market gains or losses on securities classified as AFS will now affect your capital levels. As a savvy bank person, you know that the Federal Reserve is thinking of raising interest rates soon(ish) and that such a move would traditionally spell bad news for bonds. Faced with upcoming interest rate volatility, you have two choices: a) reduce rate risk in your portfolio or b) figure out a way to avoid mark-to-market losses on the bonds.

What do you do?

If you chose b) then congratulations. You have an excellent future as a bank treasurer.

Big U.S. banks have been shifting huge chunks of their securities portfolios from AFS to HTM as they seek to offset the coming impact of a rate rise. Bloomberg News reported last year that the share of securities that the five biggest banks keep in the HTM bucket jumped to 8.4 percent, the highest in almost two decades. The trend appears to have accelerated in the ensuing months, with almost a third of the MBS on bank balance sheets now classified as HTM, according to new research from JPMorgan.

As JPMorgan analysts note: "... [B]anks have shifted nearly a third of their MBS into HTM accounts, thanks to concern about capital volatility driven by recent regulatory changes. This means that banks should ultimately be less sensitive to rate moves, since fewer securities are being marked to market." The shift makes some sense in the face of declining bank profit margins and the need to hold more lower-yielding assets that are considered super-liquid under other new banking rules.

Buying longer duration MBS and then stuffing them in HTM portfolios can help banks offset some of the lower returns on offer from investing in things such as shorter-term U.S. Treasuries.

According to Deutsche Bank analyst Chris Helwig, banks have been shifting into less-interest-rate-sensitive assets. He says more than 70 percent of the biggest banks' non-MBS bonds now have durations of five years or shorter, with a quarter of the securities in assets shorter than three months. Socking away higher-yielding, longer-duration MBS can help offset the meager returns on offer from investing in all those shorter-dated securities.

Still, banks are having to walk a fine line when it comes to determining the amount of MBS they can classify as HTM; Once bonds are labelled as HTM, they can't easily revert back to AFS.

So banks that choose to move big chunks of their portfolios into HTM had better make sure they don't ever have to sell those securities.

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