top of page

Banks Remain Under Pressure


The relationship between changes in interest rates and bank loan and securities values is a crucial area of concern for investors in bank stocks. As of September 30, 2023, nearly $1 trillion of unrealized losses threatened the strength of U.S. bank balance sheets. This is primarily due to the rate-hiking campaign the Federal Reserve started in March 2022, and is the highest level since that campaign began. With the market now anticipating significant rate cuts next year, bank management teams may be hoping that lower rates will offset the mountain of unrealized losses that have accumulated on bank balance sheets. While lower bond yields will undoubtedly help ameliorate the problem, we’re unlikely to return to a zero interest rate policy (“ZIRP”) world when most of these assets were purchased. In other words, unrealized losses will remain a large problem for banks, albeit a bit less enormous, even should the Fed cut rates.

Recent economic data has dramatically shifted market sentiment since late October, when the 10-year Treasury yield reached 5% for the first time in 16 years. Growing confidence in the Fed's ability to control inflation without causing a recession (i.e., "soft landing" scenario) has sparked a rally in Treasuries, pushed down yields and likely reduced unrealized losses by 30-40%. It’s also boosted equity values, including for regional banks: the KRE regional bank index has rebounded 35% since October 25. Futures contract prices from the CME imply the market expects a 69% chance the Federal Reserve will reduce rates by at least 25 basis points at its March 2024 meeting, and the Fed’s midpoint of its projected target range assumes at least a 100 basis point cut by year-end 2024. 

Below, we chart the path of the Federal Funds rate and the 5-year Treasury against reported unrealized losses at U.S. banks since the Fed began tightening monetary policy. Although it's not an exact science, a 100 basis point cut could reduce losses by 30-40% from the Q3 2023 peak, but that would likely still leave over $500B of unrealized losses in the banking system. Even a return to the Fed’s so-called “neutral rate” of 2.5% (which the market is not anticipating) would still leave a significant hole in the U.S. banking system. Predicting how assets reprice as rates decline is difficult and unique to every institution. We can reasonably surmise, however, that unless ZIRP returns, many U.S. banks will likely spend the next few years managing these interest rate-related unrealized losses.

The rapid shifts in sentiment since October highlight that forecasting the financial landscape carries a high degree of uncertainty. However, it seems reasonable to conclude that a return to the pre-2022 monetary policy is unlikely unless a notable economic slowdown prompts rapid rate cuts. From the perspective of banks, while such a scenario might address interest-rate related losses, it would likely come with broader economic shocks that present even more significant credit and other risks. 

It's important to note that the bulk of unrealized losses on bank balance sheets are attributable solely to rate increases – we have not (yet) seen broad deterioration in credit quality. While there have been some signs of weakening fundamentals, credit has generally held up well. However, the higher interest rates since 2022 have raised borrowing costs for businesses and consumers. The market's current expectations for Federal Reserve rate cuts might not reduce debt servicing costs enough to prevent an increase in defaults.

It’s also important to note that declines in asset values from rising interest rates translate directly into lower equity value on an economic basis, even if banks do not realize those losses through asset sales. A reduction in regulatory capital will significantly affect a bank’s ability to lend, which can impact the broader economy.  Even if not (yet) reflected in regulatory capital, a material drop in the economic value of equity will typically cause a bank to curtail lending and/or sell assets, and can threaten the stability of the banking system, as evidenced in March with the collapse of SVB (a bank with strong reported regulatory capital but essentially no capital on an economic basis at the time). And, accounting rules and regulatory capital regulations may, or may not, accurately reflect the economic value of a bank’s equity. 

Indeed, banks face operating headwinds across various macro outcomes. Proactive management teams operating from a position of strength (i.e., with sufficient capital and a strong franchise) have already begun repositioning themselves for a post-2022 world through balance sheet restructurings and M&A. Unlocking capital and building scale offer significant competitive advantages during an uncertain time. Others are biding time, betting that monetary policy (i.e., significant rate cuts) will save them. But hope is not a strategy - heading into 2024, banks will need to make hard decisions on how they plan to address interest rate risk.

Image by Warren LeMay via Flickr.


bottom of page