Silicon Valley Bank disclosed it had $1.8 billion in paper losses on some bonds at the end of 2022.

And yet the lender didn't reduce a key measure of capital strength monitored by regulators. Those losses became existential for the bank once it was forced to sell these assets, triggering a run that ended with the bank's seizure on March 10.

The U.S. banking system currently has hundreds of billions in unrealized losses lurking in its system that don't weaken buffers designed to protect banks from future shocks. Why would regulators allow that?

The short answer: Compromise.

Years ago, U.S. supervisors decided most small and mid-sized institutions could opt out of deducting paper losses on bonds from key regulatory capital levels. In essence, these banks are allowed to report assets that are stronger in theory than they would be in practice. As Silicon Valley Bank — and the broader investing public — found out earlier this month.

Giant banks, however, don't have this option as a result of post-2008 banking reforms, but they have another way to ensure sudden changes in the value of their securities don't harm capital levels required by regulators: They can shift bonds from one internal accounting category to another.

'A good compromise'

The debate about these paper losses started three decades ago with an accounting change that gripped the banking world.

A 1993 rule from the Financial Accounting Standards Board required companies to begin classifying the fair market values of debt securities in particular ways. Any bonds they intended to hold until maturity would be routed to a classification called "hold for maturity," while bonds that could be sold sooner would go in a category called "available for sale."

Any declines in the latter category would show up in a bank's public disclosures for anyone to see, but they wouldn't count as a loss against earnings until the deteriorating assets were actually sold.

Banks worried they would be punished by overseers if these paper losses mounted on their massive holdings of bonds. Their fears were reinforced by an early proposal from the FDIC requiring banks to lower key regulatory capital ratios if unrealized bond losses emerged in the available-for-sale category. Bankers pushed back, and the FDIC agreed in 1995 regulatory ratios would not suffer from declines in the value of debt securities. (Equities still had to be counted.)

"This approach is deemed proper," the regulator said in a ruling that year, citing potential volatility that unrealized losses could pose as "interest rates change." When rates rise, the value of existing bonds tend to decline.

Former FDIC Chair Bill Isaac, who is now chair of Secura/Isaac Group, said it was "a good compromise," adding: "[You] can't force banks to mark to market. Then they cannot be long term lenders."

Former FDIC examiner Allen Puwalski views it differently.

"It was a mistake from the beginning," he said. A different approach "would have stopped some of what happened. Banks would have known this is going to hit my regulatory capital." The FDIC declined to comment.

A capital buffer

What is regulatory capital and why is it so important?

Capital, also known as "equity," is what allows a bank to absorb any changes in the value of its assets and survive unexpected shocks. It is the literal difference between a bank's assets (cash, loans and investments) and its liabilities (deposits and other forms of funding).

Regulators require banks to keep key capital ratios above certain thresholds. These ratios go up if a bank earns more profits and down if it loses money on loans or investments.

If these ratios aren't high enough, the thinking goes, a bank could run into serious problems during times of stress. Regulators, as a result, use them to issue warnings and take corrective action.

Whether these measures of strength should be affected by unrealized bond losses surfaced again in the aftermath of the 2008 financial crisis when an international consortium, operating under the name Basel III, proposed paper losses on "available for sale" securities be deducted from a bank's regulatory capital levels. Specifically, a measure known as common equity Tier 1 capital.

American regulators considered adopting this proposal and faced pushback from banks and some public officials. Their compromise? The rule would apply only to banks with more than $250 billion in assets while smaller banks could opt out. Regulators moved the bar higher in 2019 to only encompass banks with more than $700 billion in assets.

Giants like JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C), or Wells Fargo (WFC) are too big to opt out of this reporting scheme.

Instead these banks are able to shift securities from "available for sale" to "hold to maturity," a classification that means unrealized losses won't affect a bank's regulatory capital ratios. Most bonds held by Bank of America are now in that bucket, for instance — at the end of 2022, its unrealized losses on those holdings were just shy of $109 billion.

'Once the horse has left the barn'

Some of these practices may change after the fall of Silicon Valley Bank, which like many banks opted out of deducting paper losses from regulatory capital ratios.

The Federal Reserve may, according to reporting in The Wall Street Journal, propose changes in the coming months that require more banks to end this practice. Across all U.S. banks, unrealized losses had ballooned to $620 billion at the end of 2022.

"The rationale for lenient capital treatment has always centered around the idea that interest rates movements would create artificial volatility in bank capital," said Puwalski, a former partner with hedge fund Paulson & Co. and chief investment officer at Cybiont Capital. "What we've just experienced is that liquidity shocks can prove the fact that it's not artificial at all."

Bank supervisors, he added, "have had at least two opportunities to get the accounting treatment right" in the 1990s and following the 2008 crisis. Now he expects regulators to act aggressively.

"One thing [regulators] are good at," he said, is that "once the horse has left the barn they really slam that door shut."

Click here for the latest stock market news and in-depth analysis, including events that move stocks

Read the latest financial and business news from Yahoo Finance