How to Value "Bank Runs" in Balance Sheet?

Silicon Valley Bank has failed, and it can be attributed to two simple explanations.

1. The deposits were repayable on call, but the bank invested nearly everything in long-dated bonds.?
2. ?Auditors looked the other way when management refused to account for losses on long-dated bond by using respectable looking props like “Hold to Maturity” HTM and “Available for Sale” AFS. These are childishly dangerous concepts that should not exist, but regulators created them so that banks can manipulate profits to their desired levels.

What are the solutions to avoid this in the future? Two solutions. One simple and one complex.

1. Kill the concepts of HTM and AFS. Simple enough. Everyone will have two less things to account for when studying the balance sheets of banks. However, it will not fly. Because then there is less scope for banks to produce the financial results that they want to show.
2. So, here comes the complex solution.?Value the liquidity option embedded in deposits repayable on call. This will create more employment for consultants, and financial analysts. Banks can continue to show what they want to show on the asset side and still, investors can better guess the value of the bank, as they have one more variable to counter the two unnecessary variables.

So, how to value liquidity options in deposits repayable on call? Three logical steps:

1. Depositors want their money back either for transactions or for fear/greed factor.
2. Ignore the transaction motivation because, on average, over the medium term, the liquidity demand for transactions will cancel out for a reasonable size bank.
3. Liquidity demand for fear/greed factor is nothing but price risk. Specifically interest rate risk. Assume deposits have a life of 5 years. So they are a 5-year bond, in which the deposit can sell back to the bank at par at any time. Valuing this option is easy.

Now that deposits are constructed as a “short position on a long-dated bond + short position on put option on the same bond,” the bank should value the short put option. After that bank should account for that value in the balance sheet.

Banks will now be wary of accepting demand deposits because they will no more?be low-cost deposits. The short position on the put option will be priced regularly, and the real cost of deposits will be known to investors.?

So, more complexity to account for complexity created by HTM/AFS. But that should be ok. Who says the world needs to go to simplicity?