The Blind Spot of Unrealized Losses

Unrealized losses on bank assets were not priced by the market prior to March 2023. Traditional risk measures and capital ratios failed to account for unrealized losses despite several early indicators. By identifying indicators such as insolvency, high uninsured deposits, and withdrawal of deposits, we emphasize the importance of incorporating unrealized losses into regulatory frameworks. We show that before March 2023, cost of capital did not vary with any early risk indicator. However, starting in March 2023 run risk became priced and both the expected cost of equity and realized returns were impacted by cross-sectional variation in the key indicators