Book Value Risk Management of Banks: Limited Hedging, HTM Accounting, and Rising Interest Rates

We document that as interest rates rose in 2022, banks limited the impact on the accounting value of their assets but left most long-duration assets exposed to interest rate risk. Call report and SEC data show that only about 6% of U.S. banking assets were hedged with derivatives, and even the heaviest users hedged only a small share of their portfolios. Rather than hedge market-value risk, banks relied on held-to-maturity (HTM) accounting to shield book capital, reclassifying roughly $1 trillion of securities as HTM once rates began to rise. More vulnerable banks, especially those overseen by less stringent state regulators, were more likely to shift into HTM. We develop a simple model of how capital regulation, accounting rules, and bank incentives interact in determining whether banks hedge interest rate risk or recapitalize. Capital regulation can reduce run risk, particularly when equity holders are unwilling to hedge or raise new capital. HTM accounting can help well-capitalized banks avoid the costs of excessively tight capital requirements, but it can also enable weaker, moderately-capitalized, banks to window-dress capital ratios, leaving them susceptible to runs. Incorporating deposit franchise value into regulatory capital without considering run risk may further weaken the effectiveness of capital regulation. These findings carry important implications for regulatory capital accounting and risk-management practices across the banking sector.