Often-overlooked securities portfolios are attracting attention from bank treasurers as the effects of higher rates reverberate throughout the industry. The value of the securities in these portfolios is falling at the same time the cost of raising and holding deposits is increasing. Already this year, unrealized losses stand at $83.3 billion, which is about 1.3 times the industry’s year-to-date net income.
Curinos believes that many banks need to get a better handle on the risks to capital and funding that are embedded in these portfolios.
When deposits exceed loan demand, banks often divert that surplus into the purchase of highly rated securities, typically treasuries and other government bonds. When rates were low and stable, their yields generally exceeded a bank’s funding costs, so there’s rarely been significant impact to a bank’s earnings or capital position. Then two things happened: the pandemic and inflation.
Because COVID-19 spawned unprecedented government stimulus and inhibited consumer spending, bank deposits surged during the pandemic, well outpacing loan demand. With the excess liquidity, banks sought the higher returns they could receive from government securities. These securities now represent as much as 40% of a bank’s balance sheet.
At times of stable interest rates, high levels of held securities, even historically high levels, might go unnoticed because banks would likely hold them to maturity, with negligible concern about duration risk. But with inflation driving up rates, funding costs are now higher than yield, and holding securities to maturity could adversely affect net interest margin and slow loan growth.
And what if high market rates persist beyond these maturities?
Scope Of The Issue
In addressing what to do with securities whose market value is less than their book value, banks have a choice. To put it simply, they can account for them as “held to maturity” (HTM) and realize their full value when maturities come due or make them “available for sale” (AFS). AFS recognizes unrealized losses to securities on the balance sheet, as “accumulated other comprehensive income” (AOCI), a line item that rises and falls with interest rates but has no effect on current earnings. The decision of how much to put in each of these accounting buckets can depend on a combination of factors, including access to deposits, capital position and desired impact on current earnings.
Because of today’s surging rates, tangible book value at the median bank has been falling this year after rising for 20 straight quarters – driven by the reduction in AOCI. Without this reduction, tangible book values would have been up 9% since the beginning of the year. (See Figure 1.)
As a result, the issue of embedded losses in securities portfolios is now on the radar of most market participants and could attract attention from regulators and/or rating agencies. Six of the top 25 banks now have tangible capital equity of 4.8% or less, which could sound an alarm about stability even though all have healthy common equity Tier 1 ratios of more than 9%. With both funding costs and deposit attrition rising, holding these securities to maturity — already 45% of industry portfolios as of September 30 — is becoming a real concern for future bank earnings. It can create a potential duration trap, especially if a bank needs to tap into its portfolio for liquidity and recognize the losses that have thus far gone unrealized.
Figure 1: Impact of AOCI on TCE Ratios
To Hold Or Not To Hold?
Held to maturity may make sense for institutions that can continue to raise deposits at an acceptable cost without relying on proceeds from the sale of securities. Because embedded losses are not realized, HTM means there isn’t an adverse effect to tangible book value, current earnings or measured regulatory capital. But holding assets with embedded losses can strain liquidity if betas continue to rise, existing deposits attrite or loans default. It also means there is that much less funding available for generating loans. And if market rates turn out to be higher than rates of these instruments when they mature, funding costs will step up accordingly. In addition, future market rates may be higher than the current rates that would apply if losses were realized today through a premature sale.
AFS, on the other hand, doesn’t adversely affect current earnings, but it does reduce tangible book value. AFS may therefore make sense for banks that have enough deposits to meet loan demand and can withstand a reduction in book value if their greater priority is to protect current earnings.
While investing in highly rated securities has been standard practice for many banks since the financial crisis, it has been tested by the recent deposit surge followed quickly by inflation. Whether to hold these securities or make them available for sale is a balancing act that banks need to strike based on their evolving circumstances and preferences.