The recent collapses of Silicon Valley Bank and two other financial institutions, following panic-induced runs on deposits, have ignited a longstanding discourse in bank regulation: determining the delicate balance between transparency and discretion. Regulators necessitate comprehensive insight into a bank’s balance sheet to enable timely intervention before its demise. However, an excess of openness could trigger premature withdrawals from a salvageable institution, exacerbating the crisis it aims to avert.
Novel research from Texas McCombs has pinpointed a potential equilibrium: an “optimal reporting system” with the potential to forestall future financial tumult. As articulated by Ronghuo Zheng, associate professor of accounting, in this proposed framework, occurrences akin to the tumultuous events witnessed at Silicon Valley Bank and its counterparts would be rendered less probable or calamitous. A central bone of contention with the existing system lies in its adoption of fair-value accounting. This methodology appraises a bank’s assets at prevailing fair market values rather than initial costs.
Nevertheless, a notable exception exists within this paradigm: the non-mandatory disclosure of so-called HTM (Held-To-Maturity) securities at fair value. These encompass 10-year U.S. Treasury bonds intended for retention until maturity. Under this exemption, a bank reports a $100 T-bond at its face value of $100 despite potential fluctuations in its market worth. For instance, on February 13th, a $100 10-year T-bond was valued at $97.16, marking a loss of $2.84.
Typically, such losses remain confined to accounting entries since the bank harbours no intent to liquidate these bonds. However, in March 2023, Silicon Valley Bank was compelled to offload these securities to meet withdrawal demands from substantial depositors. This development triggered a domino effect, prompting additional withdrawals and further bond sales, ultimately culminating in losses amounting to $1.8 billion. This predicament might have been averted had the bank disclosed the market value of its bonds, asserts Zheng. Armed with such information, regulators could have preempted the unfolding crisis.
What does an optimal reporting system entail? Drawing on a prevalent bank-run model, Zheng and Gaoqing Zhang from the University of Minnesota concluded that an optimal system would highlight the riskiest banks while protecting less vulnerable ones from debilitating runs. Striking this balance involves requiring full disclosure under certain conditions but not under others. For example, banks experiencing paper losses on HTM securities would be required to disclose such losses, alerting regulators to potential distress.
Conversely, banks reaping paper gains on HTM securities could report them to reassure depositors, albeit up to a specified threshold. Each bank would be assigned its unique threshold, customised to its susceptibility to runs and its exposure to systemic shocks like economic downturns. Gains surpassing this threshold would remain unreported. Explaining the rationale behind setting a threshold for good news, Zheng elucidates that it’s a preventive measure to shield medium-risk banks from unnecessary panic. If some banks report substantial asset gains while others report moderate gains, depositors may question the latter’s stability despite their medium risk profiles. By capping the reporting of gains across all banks, Zheng’s framework homogenises perceptions of low- and medium-risk banks among depositors, safeguarding solvent institutions from unwarranted and destabilising runs. “We only want to report the very bad banks,” emphasises Zheng. “If you are not too bad, you can stay silent.”
More information: Gaoqing Zhang et al, Optimal Reporting Systems in Bank Runs, The Accounting Review. DOI: 10.2308/TAR-2021-0626
Journal information: The Accounting Review Provided by The University of Texas at Austin