Averting Bond Losses with Accounting Twist
- March 03, 2014
- Oguz Erkol
In the world of finance is a simple fact that your bonds will lose value when interest rates go up. But the consequences of that fact are all over the place when it is a bank holding the bonds. When banks own bonds in their trading portfolio, they have what is colloquially called a trading loss due to mark-to-market accounting. Every day banks value these bonds at their day-old closing price and if the bonds went down in price, the banks simply make a loss. However when banks have bonds and other fixed-income assets into held-to-maturity to stem losses arising out of price changes. Unlike held for trading securities, temporary price changes are not shown in accounting statements for held to maturity securities. The interest income received from a held to maturity security is run through the income statement, however the gains and losses go through comprehensive income until it is realized.
In Turkey, the banks can classify their bonds as,
- Financial assets at fair value through profit or loss,
- Financial asset available for sale,
- Investments held-to-maturity,
As it is seen, assets held in trading portfolio are booked in first two classes and the held to maturity securities in the third one.
When banks foresee a pick-up in interest rates, in other words bond yields to climb, they seek to protect themselves from a weakening of their capital and move the fixed-income assets into held-to-maturity class.
I used analyzed the data of Turkish banking watchdog BRSA and found that CFOs is Turkish banks succeed at predicting the upcoming recessions.
The chart above shows available for sale securities to held-to-maturity securities ratio which plummeted just before the 2008’s global financial crisis. Afterwards liquidity injections by Fed had helped Turkish government to issue more debt securities that had been classified as available for sale by the banks. However as of the mid 2013, we reached a new turn around as banks started to book these securities as held-to-maturity assets. But the problem is that overuse of the accounting method may limit their ability to raise cash to make loans. What is more I believe that the lack of liquidity is a challenge that financial institutions in Turkey will have to face.