There is a Ticking Time Bomb in US Banking

Unrealised losses on US bank securities have risen to more than half a trillion dollars, exposing the fragility of the US financial system. This surge demonstrates that the fundamental difficulties from last year’s spring banking crisis remain unsolved, like a ticking time bomb ready to detonate at any time.

Lynn Eminent, a professor at Atlanta University in Florida, developed the US Banks’ Unrealised Losses on Investment Securities Screener, which measures the extent of unrealised losses on bank investment assets such as bonds. An unrealised loss is a potential loss that only appears on a bank’s financial statements when the underlying securities are sold.

Even during the 2008 crisis, unrealised losses never exceeded $100 billion in any quarter

However, in the first quarter of this year, they skyrocketed to $517 billion, maintaining a high level for nearly two years.

Why Does This Even Matter?

After financial crises, regulators typically identify and fine-tune the financial services system’s biggest bottlenecks. However, this hasn’t been done since the banking crisis of spring 2023. Instead, the problem was temporarily masked with loan money, central bank assistance, and support for depositors in financial systems.

The unrealised losses on securities acquired by failing banks were at the heart of the banking crisis

This scenario is unique to banks, as they are regarded differently than other businesses. While other corporations must record losses on securities in their financial results, banks often merely mention these losses in a footnote to their reports.

These unrealised losses indicate the financial hit a bank would face if it had to sell the securities on its balance sheet at market value.

Theoretically, these losses are insignificant if the bank holds the bond until maturity; for example, holding a US 10 – year bond for the full 10 years. The problem arises when the bank urgently needs cash and must sell the bond earlier.

In 2023, Many Banks Had a Need for Money

This is exactly what happened to the banks that collapsed in the spring of 2023. Depositors, many of whom wanted to withdraw their money immediately, forced the banks to sell their bonds. Essentially, it was a bank run. Since banks only keep a fraction of all deposits in their reserves (fractional reserve banking), they ran out of money.

As a result, they were forced to quickly sell a large amount of their securities and accept the losses in the short term. In this case, the crisis was triggered by government bonds, whose prices had fallen significantly due to the central bank raising interest rates.

Banks’ unrealised losses are primarily due to the decrease in bond prices resulting from rising interest rates

It is important to understand that when bond yields (interest rates) increase, bond prices fall, and vice versa. Bonds are typically recorded on the commercial bank’s balance sheet at cost because the principal amount invested is returned when the bond matures. However, if the bond’s price falls in the interim, an unrealised loss occurs, which is only reflected on the balance sheet when the bank sells the bond at the current price.

The Two Big Unsolved Problems

In summary, unrealised losses cause two major challenges for banks. First, they raise regulatory risks, which frequently result in worsening of crucial capital and liquidity ratios that indicate a bank’s soundness.

It’s worth noting that these ratios are unaffected by securities that the bank wants to hold until maturity, notably government bonds, as long as they are not obliged to sell.

These securities account for about half of the unrealised losses. The remaining half impacts the “official” health of banks, affecting their ratios and buffers according to changes in the value of their securities.

Which assets are subject to market price changes is largely determined by the bank and sometimes bank regulators

Therefore, investors and shareholders must analyse the spreadsheets themselves to ensure the numbers add up. For example, in the case of Silicon Valley Bank (SVB), the numbers didn’t add up for many investors, leading to a bank run and the eventual collapse of SVB.

Secondly, there is the previously described situation where, if a bank run occurs and banks are forced to sell these assets, the unrealised losses become realised losses. These realised losses can undermine the bank’s capital buffers and create a risk of bankruptcy.

Bank weakness also results in increased loan interest rates and an unwillingness to offer as many loans (which increases indebtedness). Because the existing monetary system is based on credit expansion, this might cause deflationary processes, reducing the money supply. This, in turn, can have a devastating effect on a credit-dependent economy.

When Did This All Start?

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). Following the 2008 financial crisis, Basel III was established as the legal framework for global banking. Under this new framework, United States Treasuries were classified as some of the safest and most liquid assets.

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

Bonds were purchased in large quantities during the 2010s and especially at the beginning of the 2020 crisis when interest rates were close to zero. However, after interest rates increased (causing bond prices to drop), the value of the bonds began to fall rapidly. It’s important to remember that when bond prices fall, their yield (interest) rises, and vice versa.

Key Takeaways

Because banks hold huge amounts of US Treasury bonds, their performance is heavily influenced by the bond market. There is reason to assume that the United States is on the verge of a debt crisis, which will be accompanied by decreasing bond prices, exacerbating the risk to banks and financial institutions.

The crisis might move into the banking sector via the bond market, leading many institutions’ capital and liquidity ratios to deteriorate. When depositors, potential investors, or shareholders see that the numbers no longer add up, new bank runs may occur, leading to another wave of bank failures.

If this happens, will the central bank be able to temporarily manage the situation and postpone the problems? We’ll see.

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