N°26-06: Underwater: Strategic Trading and Risk Management in Bank Securities Portfolios

We use bond-level data to study how US banks managed securities portfolio risk during the 2022–23 interest rate surge. Rising yields lengthened the effective duration of callable bonds (especially agency MBS) and triggered deposit outflows. Exposed banks reduced both the volume and duration of bond purchases, but rarely sold existing bonds and did not  expand qualified accounting hedges. Two frictions constrain adjustment: first, banks systematically avoid realizing losses, especially banks that exclude unrealized losses from regulatory capital. Second, hedging capacity is limited by fixed costs and callable bond complexity. Instead, banks reduced measured exposure by classifying high-risk bonds as held-to-maturity.