Adam Kolasinski is a Professor of Finance at Texas A&M University, and Nan Yang is an Associate Professor of Finance at the Hong Kong Polytechnic University. This post is based on their working article. Related research from the Program on Corporate Governance includes Lucky CEOs and Lucky Directors (discussed on the Forum here) by Lucian A. Bebchuk, Yaniv Grinstein, and Urs Peyer.
Strict securities accounting rules that require the recognition of unrealized securities losses in earnings caused banks sell mortgage-backed securities into negative liquidity shocks, a disruptive activity sometimes called, “liquidity feedback trading.” The underlying economic mechanism behind liquidity feedback trading, however, is still poorly understood. Prior scholarly research exclusively investigated a proposed mechanism related to capital ratio compliance concerns, but evidence that this mechanism played major role has proven elusive. Despite the lack of understanding of the economic mechanism behind liquidity feedback trading, in effort to prevent it, regulators in 2009 relaxed accounting rules requiring recognition of unrealized losses. For all but the largest banks in the U.S., these relaxed rules persist, so securities unrealized losses, particularly those related to interest rate movements, are often not charged to earnings or bank capital. Moreover, such unrealized and unrecognized losses featured prominently in the failures of First Republic, Silicon Valley, and Signature Banks during the spring of 2023 (e.g., Flannery and Sorescu, 2023).
