Pub 3 2023 Issue 2

RISING INTEREST RATES COMPLICATE BANKS’ INVESTMENT PORTFOLIOS By Carl White, Federal Reserve Bank of St. Louis This article is part of a series titled “Supervising Our Nation’s Financial Institutions” by the Federal Reserve Bank of St. Louis. Rising interest rates have prompted both challenges and opportunities for banks over the past year. Bank supervisors are, understandably, urging bankers to pay close attention to a myriad of ways changing interest rates can affect earnings and capital, or what’s termed “interest rate risk.” While rising interest rates give banks opportunities to increase earnings by pushing up rates charged on loans, they also could increase the cost of liabilities and decrease the value of investment securities held as assets. Even unrealized losses — paper losses — in investment portfolios can have negative effects on liquidity and present funding challenges, earnings pressures and, in some cases, issues with capital. Interest Rates and Bond Prices The inverse relationship between bond prices and interest rates means the sharp increases in interest rates this year have lowered the value of fixed-rate bonds held as investments, including those of banks. Many banks increased their holdings of bonds during the pandemic when deposits were plentiful, but loan demand and yields were weak. For many banks, these unrealized losses will stay on paper. But others may face actual losses if they have to sell securities for liquidity or other reasons. Other possible consequences of significant unrealized losses include reductions in or restrictions on borrowing capacity and declining market valuations of the affected institutions, which could have a negative impact on banks looking to engage in merger and acquisition activities. Just prior to the pandemic, roughly 20% of bank assets consisted of investment securities — primarily mortgage-backed securities and U.S. Treasury securities. By the end of 2021, security holdings had increased to 25% of assets, with most of the growth occurring in U.S. Treasury securities. Many of those purchases were for securities with longer maturities, which drop in value more than short-term securities when interest rates rise. Effects on Capital and Liquidity Losses on investment securities — realized or not — can affect a bank’s capital position. In general, banks must classify their securities into two buckets: held for maturity (HTM) and available for sale (AFS).1 The difference between the amortized cost of AFS securities and their current fair value is recorded in a category called Accumulated Other Comprehensive Income (AOCI), which is subtracted from equity capital on a bank’s balance sheet. While AOCI is excluded in measures of regulatory capital for community banks, it does affect what’s known as tangible common equity (TCE).2 TCE is declining industry-wide because of the negative effect of rising rates on the market value of bank holdings of AFS securities. The number of banks with ratios of TCE to average tangible assets of less than 5% jumped markedly in 2022, with some banks posting negative TCE. Banks in this position largely got there because of an aggressive earnings strategy based on longer-term securities holdings when interest rates were low. Banks with very low or negative TCE may face funding challenges. Federal Home Loan Banks (FHLBs), for example, are not permitted to extend new loans (called advances) to banks with negative TCE, and existing FHLB loans may not be renewed beyond 30 days unless waivers are obtained by borrowers’ primary regulators.3 That could be problematic for banks facing a runoff in deposits or other liquidity concerns; in a worst-case scenario, a bank might have to sell “underwater” bonds to raise cash, thus realizing losses and reducing regulatory capital. The Supervisory Perspective Large unrealized losses in the investment portfolio increase a bank’s risk profile, but the extent varies by bank. Supervisors are less likely to be concerned if the duration4 or maturity of a bank’s assets (loans and investments) and liabilities (deposits and other borrowings) are roughly the same. Concern would be further reduced if assets were funded by stable, non-maturity deposits, such as checking and savings accounts. To reduce risks to liquidity, capital and earnings from unrealized losses, banks can take several steps, including diversifying contingent funding sources, especially if reliant on FHLB advances. The Federal Reserve’s discount window is one option. Increasing the ratio of HTM to AFS securities through new purchases or reclassification may ameliorate declining or low TCE at some institutions, although reclassification does not eliminate the risks associated with owning fixed-income securities in a rising rate environment. In general, a bank should carefully analyze its existing capital and liquidity planning for possible adjustments based on current positions as well as the likelihood of further stress. ■ 1. Some banks (mostly very large banks) hold securities in trading accounts, and those securities are classified separately. Changes in the fair market value of these holdings flow through the income statement and are counted as current income or expense. 2. Tangible common equity is calculated as equity capital less goodwill, other intangibles and disallowed mortgage servicing rights. 3. See the American Banker article for more on the FHLB rule at https://www.americanbanker.com/news/rising-interest-rates-put-community-banks-inregulatory-bind-with-fhfa-rule 4. The change in the valuation of an asset or liability that may occur given a discrete change in interest rates. 30 | The Show-Me Banker Magazine

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