Breitbart Business Digest: Why Banks Were So Vulnerable to the Fed’s Rate Hikes

Why Silicon Valley Bank Was Exposed to Monetary Policy Changes from the Fed

The run on Silicon Valley Bank was triggered by depositor concerns over losses the bank had suffered due to rising interest rates. Which raises the question: why was the bank so exposed to interest rate risk?

Silicon Valley Bank was flooded with deposits during the pandemic and the initial phases of the recovery when its tech industry clients prospered and venture capitalists poured money into startups, creating new clients for the bank. It bought lots of U.S. Treasuries and government-backed mortgage bonds, securities that are considered safe assets because there is essentially no risk of default. As a result, the bank’s deposits and assets roughly doubled in 2021. 

When interest rates rise, however, the fixed interest payments on these securities do not keep up with the prevailing rate. An older government bond that pays two percent drops in value when the latest bonds pay twice that. The price of the older bond falls enough so that the yield more or less equals the yield on the newer bond.

Bank Bond Portfolios Singing ‘Hold Me Now’

This does not necessarily mean that the bank actually loses money on those bonds. If the bank holds the bonds until maturity, the bonds will pay off exactly as the bank expected when they purchased them. This is why they are considered “safe assets.” In fact, banks are allowed to declare that bonds they buy are going to be “held-to-maturity,” which means they do not have to mark them to market prices and can go on reporting them as being worth their face value on their balance sheet and for the purposes of regulatory capital.

The rules do not let banks entirely conceal these mark-to-market losses. Somewhere in the financial statements, usually in a footnote or appendix, banks are required to explain the difference between the market value of their bond holdings and the value listed on their balance sheet.

What’s more, if a bank ever sells any of the bonds that it has declared as “held-to-maturity,” all of the rest of its holdings get disqualified from this treatment. Which means they all have to be marked to the market value, potentially triggering a huge accounting loss. To avoid doing this, banks also hold bonds that they do mark-to-market, labeled “available for sale.” These can be sold without disqualifying other bonds from being treated as held-to-maturity.

Even the unrealized losses on those available-for-sale bonds do not hurt a bank’s net income. They get tracked under a balance sheet line called “accumulated other comprehensive income.” It’s only when a bond is actually sold at a loss that it hits the bank’s income. 

Silicon Valley Investors and Depositors’ Panic

A week or so before it collapsed, Silicon Valley disclosed that it had sold some investments at a $1.8 billion after-tax loss and would seek to raise $2.25 billion in new capital by selling common and preferred stock. The price of the banks shares plunged by 60 percent. Investors and customers began to pay attention to the fact that the bank was sitting on $17 billion of unrealized losses. Spooked investors began pulling deposits, attempting to withdraw as much as $42 billion in a single day, cratering the bank.

Of course, Silicon Valley Bank is not alone in sitting on a mountain of unrealized losses. The Federal Deposit Insurance Corporation (FDIC) said in February that across the U.S. banking system, unrealized losses on available-for-sale and held-to-maturity securities totaled $620 billion as of December 31. A year earlier, before the Fed began hiking rates, unrealized losses were just $8 billion.

So, why were banks so exposed to the risk of rising rates? One unsatisfactory answer is that banks were just caught off guard by the speed of interest rate hikes. While it is true that banks probably were caught off guard—so was the Fed itself—this does not really answer the question of why banks were taking interest rate risk in the first place. Why did banks leave themselves vulnerable to a change in monetary policy?

Bond Portfolios as a Hedge

Fortunately, there happens to be a paper published in the American Economic Journal: Macroeconomics that takes this question head-on. It is titled “Why Are Banks Exposed to Monetary Policy” and is authored by Sebastian Di Tella of Stanford University and Pablo Kurlat of the University of Southern California. It was published in October 2021 but was circulating as a working paper for a few years before that.

Di Tella and Kurlat argue that banks take interest rate risk as a hedging strategy. When prevailing interest rates are very low—as they have been in recent years—banks earn very little income from deposits. When rates rise, banks do not pass on all of the benefit of higher rates to depositors. Especially in the beginning, banks raise the rates they charge on loans but keep deposits rates low. Even when deposit rates start to climb, banks still earn a larger spread from higher rates. In an interview with Breitbart Business Digest, Kurlat estimated that banks keep about two-thirds of the benefit of higher rates and depositors get only one-third.

How do banks get away with this? Why don’t depositors just instantly move deposits to higher-interest mutual funds that own U.S. Treasuries and other safe assets? This is a bit of a mystery that the economics profession is still trying to work out, Kurlat told us.  Most likely, it is a combination of complacency and convenience. Banks offer lots of services—like ATM cards, direct bill payments, and direct deposits—that a money market mutual fund typically does not. And trying to figure out whether it makes sense to move money out of the bank takes some work that might not be worthwhile for bank customers without all that much money in the bank.

As a result, the basic business of taking deposits and making loans is itself exposed to interest rate risk. If rates fall, the deposit side becomes less profitable. If rates rise, it becomes more profitable.

The bond portfolio is a natural hedge against this. If rates fall, the bond portfolio gains while the other part of the business declines. If rates rise, basic banking business becomes more profitable, and the bond portfolio loses value. So, Di Tella and Kurlat’s paper argues that banks intentionally expose themselves to interest rate risk as a hedge against the interest rate sensitivity of the deposit business.

“The trick is to find the right amount of risk that does the job of hedging for the other business,” Kurlat explained. He said that for the typical bank, around a four-year mismatch between deposits and liabilities is probably the right level of hedging.

Silicon Valley, however, might have needed to be more conservative than most in this because of the unusual nature of its deposit funding. Its depositors were unusually wealthy and held incredibly large deposits at the bank. If you have $1 million in the bank, earning four hundred extra basis points on your savings is more likely to prompt you to relocate your funds. If you have $100 million, well, then we’re talking serious money. Trying to keep deposit rates low just will not work.

A bright side for consumers may be that a broad range of banks may now be compelled to raise rates to stem deposit outflows. On the downside for banks and their investors, this will diminish bank profits.