Underwater: Strategic Trading and Risk Management in Bank Securities Portfolios

Abstract

Using security-level data, we show that US banks display a form of the “disposition effect” – banks trade strategically to avoid selling underwater bonds. In 2022-23, when unrealized losses exceeded $600bn, banks were about 5 times more likely to sell a bond held at par, and 10 times more likely to sell a bond held at a premium, relative to a bond held at a loss. These patterns are partially driven by regulation: strategic trading is more pronounced for banks that do not recognize unrealized losses in regulatory capital. At a portfolio level, this behavior results in an asymmetric response of securities portfolio growth to positive versus negative deposit growth. Aversion to realizing losses is important because it limits banks’ readiness to liquidate risky assets and rebalance their exposure to interest rate risk during periods of rising rates. For example, sales of securities fell sharply in 2022-23 even as interest rate risk rose and many banks experienced deposit outflows – consequently the duration of bank portfolios increased over 50% both in gross terms and net of interest rate hedging, concentrated among banks with high ex ante exposure to agency MBS and other callable assets. Large banks did however reduce the net sensitivity of regulatory capital to interest rate risk in the bond book during this period by reclassifying securities.

Presented by James Vickery