There is a ticking time bomb in US banking

US Banks’ Unrealized Losses on Investment Securities Screener (US Banks’ Unrealized Losses on Investment Securities Screener) is a measure created by Lynn Eminent, a professor at the University of Atlanta in Florida, which reflects the extent of unrealized losses from bank investment assets (such as bonds). Unrealized loss is a loss that is reflected in the bank’s results only after the corresponding securities have been realized.

Below is how unrealized losses for US banks have grown. We see that even during the 2008 crisis, unrealized losses did not even reach $100 billion in any quarter. However, in the first quarter of this year, they reached 517 billion dollars, having been at a high level for almost two years.

Why does this even matter?

After financial crises, regulators tend to look at what the system’s biggest bottlenecks are and then fine-tune them. However, this has not been done since the banking crisis of spring 2023. The problem was temporarily covered with loan money, help from the central bank and help for depositors.

The epicenter of the banking crisis was the fact that the collapsed banks had accumulated unrealized losses on securities. And this can only happen in banks, because they are treated differently from other companies. Other companies must report losses on securities in their financial results, banks do not. They are usually only mentioned as a footnote in the report.

These unrealized losses reflect how much financial loss the bank would have to take if it were forced to sell the securities on its balance sheet at market value.

Theoretically, these losses mean nothing only if the bank decides, for example, to hold the bond until maturity – for example, when buying a US 10-year bond, the bank should hold it for 10 years. The problem arises when the bank urgently needs money and the bond needs to be sold sooner.

Last year, several banks had a need for money

This is exactly what happened to the banks that went under in the spring of 2023. The bonds were forced to be sold by depositors, a large part of whom wanted to get their money immediately. In essence, it was a bank run. However, since banks have to keep only a part of the volume of all deposits in their reserves (fractional reserve banking), they ran out of money. Therefore, they were forced to sell a large amount of acquired securities quickly and accept the losses. In this case, the crisis was caused by government bonds, the price of which had fallen significantly. This, in turn, resulted from the central bank raising interest rates.

Banks’ unrealized losses are mainly due to the decrease in the price of bonds resulting from the increase in interest rates. It is important to understand here that if the yield (interest) of the bond rises, the price of the bond falls and vice versa. Bonds are usually recorded in the bank’s balance sheet at cost, because the principal amount invested is returned when the bond matures. However, if the price of the bond itself falls in the meantime, an unrealized loss occurs, which is reflected in the balance sheet only when the bank sells the bond at the current price for some reason.

Below is a diagram that simplistically describes this process. There are still nuances to this process, but for the sake of simplicity, the basic sequence of how unrealized losses arise in banks has been written down.

Two big unsolved problems

In sum, there are two problems with unrealized losses for banks. First, it increases regulatory risks – in some cases, it is accompanied by a deterioration of key ratios related to capital and liquidity. These ratios reflect the health of banks. It is important to note that the ratio is not affected by securities that the bank plans to hold until maturity ( held to maturity, especially government bonds). However, this is provided that they are not forced to sell.

They account for about half of the unrealized losses. The remaining other half affects the “official” health of banks (aka the ratio and buffers) according to how the values ​​of their securities change. Which assets are subject to changes in market prices and which are not is largely up to the bank. So investors and shareholders have to do the spreadsheets themselves and see if the numbers add up. For example, in the case of Silicon Valley Bank (SVB), these numbers did not add up for many investors, which ignited a bank run and thus the collapse of SVB.

Secondly, there is the already described situation – if, for example, there is a bank run and for some reason the banks are forced to sell these assets, then they become realized losses. These, in turn, can undermine the bank’s capital buffers and create a risk of bankruptcy.

The weakness of banks, in turn, creates a situation where loan interest rates may rise and it is no longer recommended to issue so many loans (increase leverage). Since the current monetary system is built on credit expansion, this in turn can cause deflationary processes, i.e. a decrease in the money supply. This, in turn, can have a devastating effect on a credit-dependent economy.

It all started after the 2008 financial crisis

The global regulator of central banks is the Basel Committee on Banking Supervision (BCBS), a division of the Bank for International Settlements (BIS). After the 2008 financial crisis, Basel III was created, which can be considered the legal framework for global banking. In the new framework, US Treasuries were ranked among the safest and most liquid assets.

According to Finnish economist Tuomas Malinen, this meant that banks began to prefer US Treasuries as bank capital because they became equivalent to money and reserves in the central bank. This created a situation where the amount of US government bonds on the balance sheets of the banks began to grow rapidly, which in turn helped to increase the price of these bonds. Since bond prices were in a long-term upward trend, no problems arose.

Bonds were bought in large quantities just in the 2010s and especially at the beginning of the 2020 crisis, when interest rates were close to zero. After the interest rate hike (and the resulting drop in bond prices), the value of the bonds purchased began to fall rapidly. Let us remind you that if bond prices fall, the return (interest) on them rises and vice versa.

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