Sometimes problems carry their own solutions. That’s true, at least to a small extent, of the recent banking crisis.
It was largely sparked by rising interest rates, which meant losses for banks’ bond portfolios. That in turn scared depositors, leading them to flee smaller banks. But then the crisis spooked investors, pushing them to the safety of Treasuries.
And all the Treasury purchases pushed interest rates down, shrinking the losses on banks’ bond portfolios.
As a Wall Street Journal headline put it: “Banks’ Bond Losses Caused the Crisis. Now the Crisis Is Reversing the Losses.”
The turmoil led to three bank failures including Silicon Valley Bank. But now things look a little better.
To be sure, the banks’ losses on their bond holdings haven’t been eliminated, just reduced.
Bank of America, JPMorgan and Smaller Banks
Bank of America (BAC) reported Tuesday that unrealized losses on bonds that it’s holding to maturity totaled $99.08 billion as of March 31, down $9.5 billion from three months ago and $17.1 billion from six months earlier, The Journal noted.
JPMorgan Chase (JPM) had unrealized losses on its held-to-maturity portfolio of almost $31 billion at the end of March, according to its latest earnings data. That is down from more than $40 billion at the end of September, The Journal pointed out.
Of course, it’s not the big banks that are at risk of losing depositors. Customers have been flocking to them from smaller banks. But smaller banks should experience the same benefit for their bond holdings from lower interest rates as larger banks are.
At the end of last year, The whole banking sector was sitting on $620 billion of unrealized losses on their bond portfolios, according to the Federal Deposit Insurance Corp.
The Federal Reserve started raising rates last March. So you would think that at some point last year banks would implement hedging strategies to protect themselves against losses caused by higher interest rates in their bond portfolios. But apparently they didn’t.
Hedging Interest-Rate Risk
“Over three quarters of all reporting banks report [in 2022] no material use of interest-rate swaps,” according to an academic paper on the Social Science Research Network this month. Interest-rate swaps are commonly used to protect bond holdings against rising interest rates.
“Swap users represent about three quarters of all bank assets, but on average hedge only 4% of their assets and about one quarter of their securities,” the paper said. “Only 6% of aggregate assets in the U.S. banking system are hedged by interest-rate swaps.”
Banks seem a lot better equipped to take risk on the upside of a credit cycle than to mitigate risk on the downside. That’s likely because taking the risk is where money is made, while mitigating risk generally just prevents losses.
The reduction of unrealized losses that is resulting from the recent decline in interest rates hopefully won’t lead banks to believe they don’t need strong hedging strategies. Interest rates could easily rebound in a hurry. The Fed may well lift rates next month.
So we’re not out of the woods yet when it comes to the banking crisis.
