Big bold numbers, but no big deal

While unforeseen challenges will undoubtedly emerge, it is unlikely that “unrealized investment losses” will be the issue that causes banks to fail.

If the chart below unsettles you at first glance, you're not alone. But before concluding that the US banking system is on the brink of collapse, let’s explore the context that might shift your perspective.

This chart shows the unrealised losses of 4,539 institutions—comprising commercial banks and savings institutions—driven by market value declines in their investment portfolios, primarily due to rising interest rates. As of Q2 2024, these losses have surpassed half a trillion dollars, suggesting a potentially troubling outcome ahead.

The collapse of Silicon Valley Bank (SVB) in early 2023, triggered by $42 billion in withdrawals in a single day, remains vivid. In this article, I explain why the perceived risks to US markets may be overstated and why a similar scenario is unlikely in India.

How did it start?

This story begins with the aftermath of COVID-19. To prevent widespread defaults, the US government launched relief programmes totalling $4.7 trillion, strengthening household and business finances and reducing credit demand. Meanwhile, bank deposits surged by nearly 30 percent, reaching $17.3 trillion. With lower loan demand, banks turned to US Treasury bonds—safer but lower-yielding investments—purchasing a record $150 billion worth in the second quarter of the 2021 calendar year. 

All seemed well until March 2022, when the US Federal Reserve raised its benchmark rate for the first time since COVID (to 0.25–0.5 percent). Over a total 11 hikes, rates increased by 525 basis points by January 2024, marking the steepest tightening cycle since the Volcker era of the 1980s.

Many banks anticipated rate hikes but underestimated their intensity, while others, like SVB, were unprepared. Before its collapse, SVB held $216 billion in assets, $70 billion in loans, $124 billion in investments ($29 billion AFS or available for sale), $95 billion HTM or held to maturity, and $176 billion in deposits. Investments equalled 71 percent of deposits, with 77 percent in HTM securities. The AFS portfolio yielded 1.6 percent and HTM 1.9 percent, but as 10-year US yields exceeded 4 percent, both portfolios suffered marked-to-market losses of $16 billion—matching SVB’s net worth. Notably, $94 billion of its deposits were non-interest-bearing. If withdrawals had been avoided and rates had fallen below 2 percent, SVB could have remained solvent.

Why is it not so relevant now?

Firstly, the total unrealised losses exceeding $500 billion, relative to a net worth of over $2.4 trillion, are not significant enough to pose a systemic threat.

Secondly, it is not a stretch to conclude that the worst of the rate hikes is behind us. While there is debate about the speed and extent of upcoming rate cuts, the consensus is clear: rates are expected to decline from here.

Lastly, the half-trillion in unrealised losses is based on $4.4 trillion in assets (Treasury and agency securities). However, the annualised net interest income (NII) for these institutions from H1 2024 data stands at nearly $700 billion, with net operating income exceeding $250 billion.

For example, according to the latest 10-Q, JPMorgan’s unrealised losses exceed $30 billion, but its average yield now stands at 3.7 percent. Similarly, Morgan Stanley reports over $14 billion in unrealised losses, with an average yield of 3.2 percent. With a few more rate cuts, these losses are likely to decrease significantly, if not vanish entirely.

Why does it not matter for India?

In India, the Reserve Bank of India (RBI) mandates that banks maintain 18-40 percent of deposits in government securities under the Statutory Liquidity Ratio (SLR) norms, preventing excessive reliance on such investments. Unlike SVB, which invested 71 percent of its deposits in securities, Indian banks follow a more diversified approach.

The asset-liability management (ALM) framework ensures banks manage liquidity and rate sensitivity effectively, with oversight by senior management through the asset-liability committee (ALCO). Banks report structural liquidity in eight maturity buckets, allowing the RBI to monitor cash flow timings closely.

To mitigate the impact of interest rate risks, SLR securities are often held as HTM, shielding banks from mark-to-market losses. The RBI also requires banks to disclose Interest Rate Risk in Banking Book (IRRBB) under Basel-3 rules, evaluating risks through earnings and economic value perspectives.

While rising rates may reduce net worth, many Indian banks benefit from increased NII. For instance, ICICI Bank and Kotak Mahindra Bank project positive NII effects outweighing equity impacts, while others, such as State Bank of India and Bank of Baroda, find the negative impact manageable in relation to their net worth. This robust regulatory environment ensures that Indian banks remain insulated from the risks that led to SVB’s downfall.

In conclusion…

Friedrich Nietzsche was ahead of his time when he wrote “that which does not kill us makes us stronger” in his 1888 work, Twilight of the Idols. Historically, each rate hike cycle has ended in significant disruptions: GDP shrank by 20 percent following the 1980s hikes, the late 1990s cycle led to the dot-com crash, the 2005–08 cycle triggered the Global Financial Crisis, and the 2016–19 cycle was interrupted by COVID-19. Despite this cycle being the steepest since the Volcker era, its relatively smooth conclusion and orderly wind-down have raised curiosity about how this outcome was achieved. While unforeseen challenges will undoubtedly emerge, it is unlikely that “unrealised investment losses” will be the issue that causes banks to fail.