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

ABSTRACT We document that as interest rates rose in 2022, banks largely left long‐duration assets exposed to interest rate risk while shielding the accounting value of their balance sheets. Call report and Securities and Exchange Commission (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 about $700 billion of securities as HTM during the tightening period, more than twice the amount reclassified beforehand. Cross‐sectionally, banks with lower capitalization, more fragile uninsured funding, and greater long‐duration asset exposure were less likely to expand hedging during tightening and more likely to rely on HTM accounting. More vulnerable banks, especially those overseen by less stringent state regulators, were also more likely to shift into HTM. We develop a stylized model showing how higher interest rate risk, through its effects on bank solvency, run risk, and regulatory capital, shapes banks’ incentives to hedge, recapitalize, or rely on HTM accounting. While HTM accounting can help well‐capitalized banks avoid excessively tight capital constraints, it can also weaken hedging incentives among weaker, moderately capitalized banks by allowing them to window‐dress capital ratios while remaining exposed to runs. Our evidence suggests that this latter channel dominated during the tightening episode. Incorporating deposit franchise value into regulatory capital without accounting for run risk may further weaken the effectiveness of capital regulation. These findings carry important implications for regulatory capital accounting and bank risk‐management practices.