Article
By Paul H. Kupiec
American Enterprise Institute
February 20, 2024
Introduction
Federal officials, including the Secretary of the Treasury, the Comptroller of the Currency and the chairpersons of Federal Reserve Board and FDIC, routinely assure the public that the banking system is well capitalized and secure. The Financial Stability Oversight Council, a group headed by the Secretary of the Treasury with voting members from every important federal financial regulator, has identified climate change and lightly regulated non-bank financial institutions, as the most likely sources of financial sector “systemic risk” that, unless brought to heel by new regulations imposed by an FSOC member agency, could cause the next financial crisis.
By any objective measure, at the time this article is being written, the biggest systemic risk is hiding in plain sight in the banking system. The risk is not a consequence of climate change, unregulated non-bank financial institution activities, or pathologically reckless bank investments, but of the massive unrealized interest rate losses that are the legacy of aggressive COVID19 stimulus policies adopted by Congress and the Federal Reserve.
Accounting for unrealized market-value losses on banks’ securities and loan investments caused by the secular increase in interest rates that began in early 2022, I estimate that, as of September 30, 2023, the banking system in aggregate had accumulated over $1.5 trillion in unrealized market-to-market interest rate related losses on its fixed rate securities, loans and lease investments. These unrecognized losses dramatically increase the probability that the federal government will have to intervene and provide blanket deposit insurance guarantees to stop systemic bank runs should depositors lose confidence in the safety and soundness of the banking system.
The banking system is far from well capitalized if the loss absorbing capacity of its capital is estimated using realistic market value of bank assets instead of reported book values. My estimates suggest that unrealized interest rate losses have erased more that 70 percent of the total loss absorbing capacity of the banking system’s reported Tier 1 regulatory capital. As of September 30, 2023, 2372 banks that collectively held 54 percent of the total assets in the banking system had mark-to-market adjusted Tier 1 leverage ratios under 4 percent, the regulatory prompt corrective action threshold that classifies a bank as “undercapitalized”. When the COVID19 pandemic reached the US in March 2020, Congress immediately responded by passing economic rescue bills that injected over $2.4 trillion into the US economy in the form of household stimulus checks, forgivable small business Paycheck Protection Program loans, and funding for COVID19 testing and inoculation programs. Over the next year, additional COVID19-related legislation added further economic stimulus. All told, Congress authorized more than $5.9 trillion in COVID19-related expenditures that fattened business and households’ bank account balances. The Federal Reserve System did its part by reinstating a near-zero interest rate policy and quantitative easing open market securities purchases. Fed QE purchases injected trillions of dollars of new bank deposits into the banking system.
In the COVID19 era near-zero interest rate environment, holding bank deposits cost banks money unless they put deposits to work in investments that earned them a positive interest margin. Banks have to pay deposit insurance premiums on deposit inflows and incur costs providing deposit account services. These costs quickly erased any interest banks could earn by keeping deposits at the Fed or investing in short-term Treasury securities. Many bankers used the influx of new deposits to purchase long-maturity federally guaranteed mortgage-backed securities, US Treasury securities and residential mortgage loans. These investments offered a modest interest rate term-premium while garnering favorable regulatory risk weights that limited the additional regulatory capital banks needed to hold these new investments.
The return of inflation, a seemingly predictable consequence of simultaneous massive federal COVID19 stimulus payments, expansive monetary policy, and state government declared public health emergencies that shut down large segments of the economy, precipitated interest rate increases that eroded the market value of many banks’ assets. Bank unrealized interest rate driven losses are real losses but go unrecognized in official bank regulatory capital measures. They are hidden by the so-called Basel risk-based capital regulations that the US and much of the world has adopted to measure the capital adequacy of banking institutions.
I analyze the implications of the post-March 2022 increase in interest rates for the capital adequacy of the banking system through September 30, 2023 using publicly available bank regulatory “Reports of Condition and Income” (Call report) data. I compare an official regulatory measure of bank capital adequacy to capital adequacy measures that are adjusted to reflect reported and estimated unrealized mark-to-market losses on banks’ fixed rate securities, loan and lease portfolios. I measure the impact by sequentially adjusting banks’ reported bank Tier 1 leverage ratios to reflect unrealized market value losses in different bank investment categories’ that have been incurred as a consequence of rising interest rates. The magnitude of banks’ interest rate losses suggests that relatively few banks actively hedged their interest rate risk during this period. I confirm this by examining regulatory data on banks’ use of interest rate derivative contracts to hedge their securities, loan and lease interest rate risk. Relatively few banks purchased significant derivative contract interest rate risk protection during the time period in question.
The analysis that follows is implemented on a bank-by-bank basis but is presented from a banking system perspective to focus on the systemic risk implications and avoid calling attention to any single institution. The implication for systemic risk is measured by the number of banks and the share of banking system assets held by institutions that would be undercapitalized under regulatory prompt corrective action guidelines after their Tier 1 leverage ratios have been adjusted for various sources of unrealized interest rate driven losses.
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