We use bond-level data to study how U.S. banks manage risk in their securities portfolios, focusing on the period of rapidly rising interest rates in 2022-23, and examine the role of financial and regulatory frictions in shaping bank behavior. Interest rate risk in bank portfolios increased sharply as rates rose, with significant cross-bank heterogeneity depending on ex ante holdings of bonds with embedded options. In response, exposed banks shortened the duration of bond purchases but did not actively sell risky securities or expand “qualified” hedging activity; securities also played a limited role in banks’ responses to deposit outflows. We identify two frictions that can help explain this inertia. First, we find that banks are highly averse to selling underwater bonds at a discount to book value—e.g., banks were 8-9 times more likely to trade bonds with unrealized gains than unrealized losses in 2022-23. This “strategic” trading is more pronounced for banks that do not recognize unrealized losses in regulatory capital and banks facing stock market pressure. Second, frictions in establishing qualified accounting hedges limited hedging activity depending on bond type and accounting classification. Banks did, however, reduce the interest-rate sensitivity of regulatory capital by classifying the riskiest bonds as held-to-maturity.

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