Lenders have stronger balance sheets now as they face a new rate-rise cycle
By Telis Demos
When the Federal Reserve starts raising interest rates, the market immediately starts to wonder: What will break?
During the last cycle of rising rates, which started in 2022, one thing that broke was regional banking. Lenders such as Silicon Valley Bank, which had invested low-cost deposits into low-yielding bonds, saw the value of those bonds plummet as yields surged, opening up capital holes that contributed to customer outflows. This culminated in a mini banking crisis by early 2023.
However, the situation in U.S. banking now has some important differences from four years ago. Banks are still sitting on billions of losses on older bonds, and those losses will likely move higher as yields do. Yet those portfolios have shrunk as a percentage of banks' size and capital, and they have shifted toward shorter-term bonds.
This doesn't mean banks are going to get off scot-free if the Fed keeps pushing rates higher, or if longer-term bond yields stay high for a long time. But much of that is due more to the kinds of broader economic concerns that will start to hit everyone in the market.
Overall, as of the second quarter banks' unrealized losses on securities stood at just under $330 billion, according to the Federal Deposit Insurance Corp. Banks collectively have also added capital in recent years. As a percentage of banks' so-called Tier 1 capital, those losses have gone from over 33% in the third quarter of 2022, to around 14% as of the second quarter this year, FDIC data show.
Of course, bonds have experienced losses in value since the end of the second quarter as yields have risen. But the shortening maturity of banks' portfolios can help to cushion that move, because shorter-term bond prices are less sensitive to yield changes.
The share of banks' debt securities portfolios with at least four years of remaining maturity hit over 20% of assets in 2021, according to regulatory data compiled by BankviewUSA.com. As of the second quarter of this year, that had dropped to under 16%.
Overall, banks' debt securities portfolios have been shrinking as a percentage of their total assets. And that has another upshot: Banks can be more exposed to the benefits of higher rates.
Recent growth in lending both to other financial institutions, like private-credit funds, and more recently to commercial and industrial borrowers, has been a factor in leaving banks with a larger portion of their assets in lending that is often floating-rate, whose yields rise with shorter-term rate benchmarks.
The share of U.S. banks' assets represented by loans that will mature or reprice within three months dropped below 20% for the first time in at least two decades in 2021, according to BankviewUSA.com data. As of the second quarter, that ratio had risen back above 25%.
Analysts are expecting the average net interest margin -- or what a bank earns in yield versus what it pays out in funding costs -- across KBW Nasdaq Bank index members to rise in the third quarter from the second quarter, and to rise next year as well. This is according to estimates compiled by Visible Alpha.
Yet investors don't seem reassured by that. The KBW Nasdaq Bank index has slumped almost 9% over the past month, while the S&P 500 has managed a small gain.
This suggests that investors might already be fast forwarding to the parts of the rate cycle that are bad for banks.
One concern is what happens when deposit costs rise. Normally, there is a lag to this effect as rates rise, because customers don't immediately move their cash. But banks have already widely reported intense deposit competition and pressure from savers who have been awakened by several years of higher rates. The newest fear is that artificial-intelligence agents might help to overcome customers' inertia to leave their money where it is for a while.
Another tough question is what happens to borrowers facing higher financing costs. While banks may for a while reap the benefit of loans repricing at higher rates, some borrowers may face strain operating at that level of debt cost.
There is already a lot of worry about this for direct loans made by private-credit funds. Many bank commercial loans are often backed by collateral that cushions losses, including the lending they do to those lending funds. Still, after years of strong credit performance, a pickup in losses could be jarring.
Perhaps this interest-rate cycle will be gentle enough to ultimately deliver more upside than downside by the end of it. But bank investors might be too skittish to stick around and find out.