The sharp rise in market interest rates since early 2022 has led to a decline in the fair value of the securities and loans U.S. banks hold on their balance sheets, and this trend has garnered significant attention following bank failures in March and April 2023, adding to confidence sensitivity risks.

S&P Global Ratings has addressed banks' unrealized losses in several publications over the past year, including "Credit FAQ: How Unrealized Losses On Securities Affect U.S. Bank Ratings," published Dec. 13, 2022. In that article, we answered several frequently asked questions on how U.S. banks account for their securities, how changes in securities valuation affect capital and liquidity, and how we factor these changes into ratings, among other topics.

Below we respond to some additional key questions about unrealized losses on banks' securities and loan portfolios. It may be helpful to read the previous FAQ, which covers key background information on accounting and regulatory capital treatment, in conjunction with this one.

In this publication, "banks" primarily refers to U.S. banks. For our comments on unrealized losses for banks outside of the U.S., please see the "Related Research" section.

Frequently Asked Questions

In S&P Global Ratings' opinion, how much risk do unrealized losses pose to rated banks in the U.S., and what are some mitigating factors?

Following bank failures in March and April 2023, concern about unrealized losses on U.S. banks' securities and loan portfolios spiked, heightening banks' sensitivity to depositor confidence.

We believe that all else equal, banks with a combination of significant unrealized losses and funding concentrations face the greatest risk of a loss of depositor confidence and sharp deposit outflows. But market conditions and idiosyncratic factors--such as exposure to riskier asset classes, management decisions and public communications, and asset size--could also affect the odds of deposit outflows, making it difficult to gauge the risk with precision.

That said, we believe the risks associated with unrealized losses are generally manageable for banks that we rate in the U.S., given some key mitigating factors.

First, we believe the Fed's emergency measures have enhanced banks' access to liquidity. In our view, the measures have also lowered the odds that banks will have unmanageable deposit outflows that drive them to sell or borrow against those securities in the first place. Through the Fed's Bank Term Funding Program, banks can borrow at a 100% advance rate against the par value of their securities. In other words, that program offsets any negative impact to liquidity from falling securities values.

Second, we believe rated banks in the U.S. generally have less significant unrealized losses relative to capital and depositor concentrations than the largest banks that failed. For instance, even if we deducted all unrealized losses on securities and loans at a tax-adjusted rate from Tier 1 capital, the median Tier 1 ratio for rated banks would have been about 7.5%, with no bank having a ratio lower than 3%, in first-quarter 2023.

That ratio improved in the first quarter compared with the prior two quarters largely because of a decline in unrealized losses. Data from banks insured by the Federal Deposit Insurance Corp. (FDIC) shows that unrealized losses fell by 25% in the fourth quarter of 2022 and the first quarter of this year. By our estimate, the two largest banks that failed would have had low-single-digit and negative Tier 1 ratios, adjusted for all unrealized losses, as well as substantial reliance on uninsured deposits with concentrations.

Third, despite reduced asset valuations, we think most rated banks have experienced manageable changes since the end of 2021 in their economic value of equity (EVE)--defined essentially as the net fair value of the balance sheet. (We provide further detail on this concept in a later question.)

Lastly, we expect FDIC-insured banks to produce adequate profits this year, with a return on equity of 9%-11% in aggregate--not materially different from last year. In our view, rising funding costs will weigh on net interest income and profitability in the coming quarters. Still, net interest income is starting from an elevated point after sharply rising in 2022, and we expect it to be higher in 2023 than in 2022, supporting overall profitability.

Chart 1

Where have unrealized losses trended recently, and where might they go from here?

The unrealized losses of FDIC-insured banks declined to about $515 billion at the end of the first quarter of 2023 from a peak of close to $700 billion in the third quarter of 2022, as longer-term interest rates ticked down despite a continued increase in short-term rates.

The path of unrealized losses in the near term will depend largely on market interest rates. If medium- to long-term rates rise again, unrealized losses could grow further. For instance, mortgage rates will play an important role in driving unrealized losses on mortgage-backed securities (MBS). Conversely, if rates fall, perhaps if inflation falls further, unrealized losses will likely drop.

Otherwise, unrealized losses will effectively amortize down as securities move toward their maturity. For securities with long durations, that will take significantly more time.

Chart 2

What will determine whether S&P Global Ratings takes further negative rating actions on U.S. banks in relation to interest rate risk, unrealized losses, deposit outflows, or other related factors?

As part of our ratings surveillance, we continue to actively gauge which banks could be most susceptible to a loss of depositor confidence, substantial deposit outflows, or general interest rate risk and profitability pressures.

To start, we consider the extent of unrealized losses in relation to capital and funding concentrations. On top of that, we look at a variety of other factors, such as recent changes in deposits and funding, exposure to riskier asset classes such as office loans, access to primary and contingent funding and liquidity sources, and any evidence of a deterioration in confidence in individual banks.

In May 2023, we revised our outlooks on the ratings on seven banks to negative from stable, signaling we could lower those ratings if we see risks materialize beyond what we expect. We affirmed our ratings and maintained the stable outlooks on two other banks (see "U.S. Banking Sector Risk Should Remain Manageable While Headwinds Persist For Certain Banks," May 15, 2023).

While most ratings have stable outlooks, we could revise outlooks to negative or lower our ratings on banks that show growing weaknesses in any of the above factors.

What caused the rise in unrealized losses?

Banks grew their securities portfolios substantially in 2020 and 2021 as quantitative easing, accommodative monetary policy, and fiscal support fueled outsize deposit growth, leaving banks with substantial funds to allocate. Banks generally chose to place a portion of those funds in securities, most notably Treasuries and Fannie Mae and Freddie Mac MBS. Deposits held by FDIC-insured banks increased more than $5 trillion in 2020 and 2021, funding a 57%, or $2.3 trillion, rise in securities and a $1.7 trillion rise in loans.

Banks likely saw those securities as a reasonably safe way to allocate funds because those securities have low credit risk, carry low risk weightings in regulatory capital ratios, and can be pledged as collateral for borrowings from the Federal Home Loan Banks (FHLBs) and the Fed and in the repo market. Banks also sought the extra yield such securities had at the time relative to holding cash and might not have expected the Fed to tighten monetary policy as much as it has. Moreover, some banks might have chosen to invest in fixed-rate securities as a means of limiting the perceived high asset sensitivity of net interest income. (If a bank has asset sensitivity, its net interest income will rise when market interest rates increase and fall when they decrease.)

In 2022, the Fed's sharp tightening of monetary policy, including through quantitative tightening, and the associated rise in market interest rates caused the fair value of those securities to fall meaningfully. The fair value of FDIC-insured banks' available-for-sale (AFS) and held-to-maturity (HTM) securities was 9% below their par value at the end of the first quarter of 2023. At the end of 2021, the fair value of securities was roughly flat with par value, meaning the drop in value has been the sharpest in many years.

To date, MBS guaranteed by Fannie Mae and Freddie Mac have accounted for the largest portion of unrealized losses. Such MBS are collateralized largely by 30-year fixed-rate mortgages. The effective maturity of such securities tends to be far shorter than 30 years because homeowners pay down the underlying mortgages when they refinance or sell their homes. However, when rates rise, the effective maturity of MBS extends--mostly because fewer borrowers refinance and repay their mortgages--pulling down the fair value of the MBS. In other words, the value of fixed-rate MBS falls amid rising rates, not only because of the rise in market interest rates but also because of the elongation of the expected maturity.

MBS have fallen more sharply in value than in prior rate cycles likely because the Fed's quantitative easing and tightening caused mortgage rates to move more dramatically, down and up, than in past cycles.

The fair value of banks' loan portfolios has also dropped, though likely by less than the fall in the value of their securities. Although disclosure on loan valuations is limited, we believe the median fair value of the loans of the U.S. banks we rate has declined by a low- to mid-single-digit percentage.

What are some of the key ways banks manage interest rate risk?

Banks typically gauge their interest rate risk in large part by estimating the impact of hypothetical market interest rate shocks on net interest income, assets, liabilities, EVE, and ultimately earnings and capital. EVE is the difference between the fair value of all assets and the fair value of all liabilities, with those fair values estimated based on discounted cash flows and other methodologies. Changes in the fair value of securities, loans, other assets, deposits, and other liabilities all affect EVE.

Typically, banks try to manage their balance sheets to limit the impact that changes in interest rates can have on their net interest income and EVE. For instance, a positive or negative change in market interest rates could cause the yields a bank earns on assets to adjust faster or slower than the cost it pays on liabilities, benefiting or hurting its net interest income. Similarly, a change in rates could cause the fair value of its assets to change more or less than any change in the value of its liabilities.

In our ratings, we consider how significant movements in interest rates could affect the performance of the bank as well as its balance sheet. A bank with a conservative approach to interest rate risk, in our view, will avoid making a large bet on interest rates moving in a certain direction. A bank may set internal limits, approved by management or the bank's board, on how significantly its net interest income and EVE should move with a hypothetical move in market interest rates. In the U.S., many banks disclose how changes in interest rates could affect their net interest income, but most do not disclose the same impact analysis for EVE.

We believe banks historically focused in large part on managing their EVE risk and less so on managing the fair values of their HTM securities and loans on a stand-alone basis. Nevertheless, unrealized losses on HTM securities and loans have come under scrutiny in recent months.

Do banks typically use financial hedging strategies to manage interest rate risk on their securities?

Banks typically do not use a significant number of derivatives or other financial hedging strategies on their securities, particularly those classified as HTM. Instead, they tend to focus on managing EVE, net interest income, and any impact of valuation changes in AFS securities on capital and liquidity.

They may not view financial hedging strategies, which can be expensive and a cause of income statement volatility, as crucial. For instance, the common strategies for hedging interest rate risk on MBS may not qualify for hedge accounting. That is, the bank likely could not treat the change in the fair value of the hedged security and the offsetting change in the hedge value as one in its financial reporting. Instead, it would have to report the two separate valuation changes, which could create significant volatility in the bank's financial reporting.

Furthermore, accounting rules generally limit banks' ability to hedge the interest rate risk on HTM securities. Such hedging could call into question their intent to hold the securities to maturity. Still, banks have full discretion to classify securities as AFS and employ hedging.

While they likely used only limited financial hedging strategies, we believe many banks tried in 2021 and 2022 to limit the risk that rising unrealized losses on AFS securities could eat into their shareholders' equity (and their regulatory capital, in the case of the largest banks) by classifying an increasing portion of their securities as HTM. FDIC-insured banks classified about 45% of their debt securities as HTM in first-quarter 2023 (measured at fair value), up from 26% in 2019--even though doing so limits their financial flexibility, since the HTM classification essentially means the bank will not sell those securities.

When a bank sells an HTM security, it could jeopardize its ability to classify any security as HTM. It may have to reclassify its HTM securities as AFS and recognize unrealized losses in accumulated other comprehensive income. (There are certain exceptions that allow the sale of HTM securities without having to reclassify all other securities as AFS.) The sale could also raise qualitative concerns about risk and liquidity management.

The HTM classification can materially affect the speed at which a bank can monetize its securities. The quickest way to monetize is to sell, particularly in the deep markets for Treasuries and Fannie Mae and Freddie Mac MBS. Without reclassification, a bank cannot sell HTM and must turn to borrowing against such securities. It can be far more time intensive to borrow a substantial amount quickly against such securities through the repo market or from the FHLB system. For instance, an FHLB may have to issue debt itself to fund a large borrowing from a bank.

How have changes in the fair value of securities and loans compared with changes in the fair value of deposits and EVE since the end of 2021?

Deposits in the banking system rose materially in value in 2022, likely exceeding the decline in the fair value of banks' securities and loans, by our estimate. While deposit values are now falling as the rise in their cost has accelerated, we believe the EVE of rated banks at the median was little changed in the first quarter of 2023 compared with year-end 2021. Specifically, the fair value of securities held by FDIC-insured banks in the first quarter of 2023 was $515 billion lower than their cost basis, as shown on bank regulatory filings.

Many banks also report their estimates of changes in the fair value of loans in their SEC filings. Most banks we rate reported that the fair value of their loans was lower than the cost basis of those loans by a low- to mid-single-digit percentage as of first-quarter 2023.

Assigning a fair value to deposits is less straightforward than doing the same for securities. That value is heavily influenced by the strength of the deposit franchise and a bank's relationships with its customers. Furthermore, a large portion of deposits, known as "nonmaturity deposits," have no set maturity (e.g., checking accounts). To value them, banks must make assumptions about the effective lives of those deposits and how quickly their cost will rise or fall with changing market interest rates. They factor those assumptions into their models, which typically use a discounted cash flow or present value approach to valuation. Banks often do not disclose these estimates publicly.

When managing their EVE, banks face the risk of inaccurately estimating the value of their deposits based on assumptions that ultimately prove faulty. Their deposits may rise in cost or run off faster than they expect, making their deposits less valuable than they anticipate and negatively affecting their EVE. Because of that, we believe it is important that banks stress their EVE risk management with varying assumptions about rates and the life and cost of their deposits.

Using our own assumptions, we estimate that the fair value of deposits held in the banking sector rose materially in 2022 and has been falling in 2023. In our calculation, we approximated the value of deposits for year-end 2021, 2022, and first-quarter 2023 with a present value approach and took the difference between the estimates. We held the level of deposits flat (at the year-end 2021 amount) and assumed a deposit life of three to five years. We discounted the cost of the deposits based on the average rate paid on total deposits in each quarter at a rate equal to the corresponding Treasury rate at the end of each quarter.

Incorporating these assumptions on banks' deposits, we believe the EVE of rated banks was little changed at the median between the end of 2021 and the first quarter of 2023. That said, we expect EVE to fall during the remainder of 2023 for many banks as funding costs climb, eating into the value of deposits.

What are some of the key elements of supervision and regulation that pertain to interest rate risk management?

In an advisory on interest rate risk management from 2010, U.S. bank regulators reminded banks that they expect them to exercise sound practices for measuring, monitoring, and controlling interest rate risk exposures. In that advisory, which followed a 1996 policy statement on interest rate risk, regulators provided banks with guidance on several aspects of interest rate risk management, including measuring the potential impact of a rise in rates on earnings and EVE. That guidance has remained in effect, allowing supervisors to point to it as they consider banks' interest rate risk management.

As it pertains to regulation, interest rate risk has limited impact on banks' compliance with various quantitative capital and liquidity requirements. Regulatory capital ratios mostly reflect credit, market, and operational risks. Interest rate risk plays a role in the market risk-weighted assets that factor into regulatory capital ratios, but that mostly pertains to trading assets rather than the securities banks hold and classify as AFS and HTM.

Unrealized losses on AFS securities count in the regulatory capital ratios of the largest banks--specifically, those considered Category I and II banks (respectively, the global systemically important banks and those with either at least $700 billion in assets or $75 billion in cross-jurisdictional activity) under the Fed's enhanced supervision tailoring rules.

However, U.S. regulators give other banks the option of neutralizing unrealized gains and losses on AFS securities in their calculation of regulatory capital. Nearly all those banks choose that option. (Unrealized losses on HTM securities have no impact on the regulatory capital ratios of any U.S. banks.)

Likewise, in our primary measure of a bank's capital, our risk-adjusted capital (RAC) ratio, we neutralize the impact that unrealized losses and gains on debt securities have on shareholders' equity. That is, we do not count unrealized gains or losses on debt securities in total adjusted capital, the numerator of the RAC ratio. (However, we do not neutralize unrealized losses and gains on equity securities.)

Still, while we do not reflect unrealized losses and gains in total adjusted capital, we consider their magnitude, their impact on liquidity, and the probability that they could result in realized losses. We could adjust our capital assessment for a bank if we were to believe that the RAC ratio overstated or understated the strength or weakness of a bank's capital, and we could consider unrealized losses as part of that analysis. Specifically, our criteria allow for an adjustment of the capital assessment after consideration of the "relative strength or weakness demonstrated by other capital metrics."

Unrealized losses on AFS and HTM securities can affect the consolidated liquidity coverage ratio (LCR) that large banks are required to meet. The LCR counts securities at their fair value rather than their cost basis (or par value). Still, unrealized losses were not large enough in recent quarters to jeopardize those banks' compliance with their required LCRs.

We believe that's due in part to how the consolidated LCR is calculated, which limits how much of the high-quality liquid assets of a subsidiary that is also subject to LCR can be counted in the consolidated LCR. Because the securities of most companies are held mostly at regulated subsidiaries, their decline in value likely didn't have a large impact on the consolidated LCR, though it might have affected subsidiaries' LCRs. The securities valuations of the large banks subject to LCR were about 9% lower than their cost basis in the first quarter of 2023.

Beyond their regulatory capital and liquidity requirements, banks typically manage their interest rate, capital, and liquidity risks with a variety of internal metrics, setting minimum limits. Regulators review that management and those limits.

For banks that did not show significant declines in EVE or their regulatory capital and liquidity requirements, why does it matter that the value of securities fell?

We believe unrealized losses can pose confidence sensitivity risks to a bank, hurt liquidity and capital, and reduce financial flexibility. That's the case even if those unrealized losses have little impact on the bank's regulatory capital ratios and are offset by a rise in the value of its liabilities.

Typically, the counterparties, investors, and depositors in banks may look to regulatory ratios. However, at times they may also consider tangible capital ratios, particularly when a bank comes under stress. For instance, recently, tangible capital ratios, as well as tangible capital ratios adjusted for unrealized losses on HTM securities and loans, have come into focus and raised questions about banks' risk management.

Even if banks look healthy by many metrics, a perception that they have a weakness because of unrealized losses can result in pressure via depositor and counterparty concern.

Furthermore, unrealized losses can also make it more difficult for a bank to sell itself during a time of stress. As part of an acquisition, the acquired assets must be marked at fair value on the balance sheet of the acquirer. As a result, the buyer may have to allocate a significant amount of equity to those acquired assets.

Banks with significant depositor concentrations or a large proportion of uninsured deposits can be more vulnerable to confidence sensitivity risks. When deposits run off quickly, a bank typically will first use cash to meet the outflow and then turn to selling or borrowing against assets, usually securities. Because a sale of securities can result in a realization of any interest-rate-driven losses (or gains, depending on the point in the interest rate cycle), the bank likely will try to borrow against the securities from sources like the FHLB system or the Fed discount window.

However, even if the bank can garner enough liquidity to meet deposit outflows by borrowing against its assets, it will effectively replace deposits with secured funding. Because secured funding tends to be costlier than deposits, the bank's profitability will likely take a hit and its financial flexibility will diminish as it encumbers its assets. While banks often tap sources of secured funding in the normal course of business, a large deposit outflow that causes a bank to become overly reliant on secured funding can jeopardize the bank's viability, even if it is able to meet the outflow by borrowing against assets.

How does S&P Global Ratings expect banks and regulators will change their approach to interest rate risk management and unrealized losses after this experience?

We assume banks will enhance their interest rate risk management to lower the odds that unrealized losses on securities and loans will rise sharply. Banks that have focused largely on managing EVE presumably will also aim to avoid the confidence sensitivity risks that can arise with unrealized losses on securities and loans.

Regulators have already indicated they will pursue regulatory updates in a number of areas, including interest rate and liquidity risk. Michael Barr, vice chair of supervision for the Fed, addressed some of those potential changes in his recent report "Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank."

For instance, he said regulators need to evaluate how they supervise and regulate a bank's management of interest rate risk and that they should require a broader set of banks to take into account unrealized gains or losses on AFS securities. In addition, Barr said regulators should consider applying standardized liquidity requirements to a broader set of firms and reevaluate the stability of uninsured deposits and the treatment of HTM securities in the standardized liquidity rules and in banks' internal liquidity stress tests.

Also, the FDIC, in a recently released comprehensive overview of the deposit insurance system, laid out three options for deposit insurance reform. It stated "targeted coverage," of those options, would best meet the objectives of financial stability and depositor protection relative to its costs.

Targeted coverage, which would require congressional action, would offer different deposit insurance limits across account types, with business payment accounts receiving significantly higher coverage than other accounts. If it is instituted, we believe targeted coverage would reduce some of the risk of deposit outflows.

Related Research

• What Declining Commercial Real Estate Values Could Mean For U.S. Banks, June 5, 2023
• U.S. Banks Webinar Discusses Navigating Challenging Conditions, May 23, 2023
• U.S. Banking Sector Risk Should Remain Manageable While Headwinds Persist For Certain Banks, May 15, 2023
• Unrealized Losses: The Rate-Rise Risk Facing Banks, March 16, 2023
• How Unrealized Losses On Securities Affect U.S. Bank Ratings, Dec. 13, 2022