The Impact of Rising Rates on the Banking System

January 5, 2023

Robert Hajduch, Managing Director, Taxable Credit Research

At his November 30, 2022 nomination hearing with the Senate Banking Committee, Acting Chairman of the Federal Deposit Insurance Corporation (FDIC) Martin Gruenberg called attention to “an overhang of unrealized losses on the books of our banks.” As Gruenberg notes in the FDIC’s Quarterly Banking Profile, one of the risks posed by these unrealized losses is that they could become actual losses if banks need to sell these investments to increase liquidity. The catalyst for the unprecedented negative repricing of investment securities held by the banking system is the Fed’s aggressive tightening policy, which ramped up significantly in 2022. As demonstrated in the chart below, unrealized losses of Held-to-Maturity (HTM) and Available-for-Sale (AFS) securities totaled $690 billion as of Q3 2022, up close to 50% from Q2 2022. 


The phenomenon has also caught the attention of ratings agencies, with both Moody’s and Standard & Poor’s publishing sector commentaries focused on the issue. All three institutions concerns concentrated on the negative impact on system capital levels and the implications for systemic liquidity over a longer time horizon.

At the heart of the issue is an accounting concept introduced by FASB in 1997 that created “Accumulated Other Comprehensive Income” (AOCI) accounts in the equity section of bank balance sheets. Securities designated as HTM are allowed to be carried at book value (cost) and are not marked to market. Securities holdings designated as AFS, however, are carried on balance sheet at market value, and while unrealized gains are not run through the income statement, they can positively and negatively impact bank capital positions.

The downward pressure on system equity capital since the Fed began the most recent tightening cycle is visible in the circled area in the following chart. While the impact is tangible, the decline in the total equity to total assets ratio since the end of 2019 has been largely driven by capital returns (dividends and stock buybacks) interrupted by regulatory restrictions over the course of the COVID pandemic. Positively, the ratio has remained stable over the trailing two quarters, and while we expect the central bank to continue to raise interest rates into 2023, further hikes are anticipated to be less aggressive than those in 2022.


More encouraging is the reemergence of loan growth since the third quarter of 2021. Government stimulus programs, coupled with quantitative easing by the Fed, flooded the economy with liquidity while loan demand was stifled by quarantines and lockdowns. As illustrated in the chart below, loans as a percentage of system assets touched a low of 47.3% at the end of the third quarter of 2021, with the ratio climbing higher in every quarter since. While currently well below the 83.7% average gross loans to total assets ratio since the beginning of 1994, the improvement to 51.2% at the end of the third quarter of 2022 is nevertheless significant, and the replacement of securities holdings with loans lessens the AOCI impact of rising rates moving forward.


System liquidity has moreover remained deep even as banks have begun to experience deposit outflows, with deposits equivalent to more than 78% of total system assets at the end of the third quarter of 2022. Per Fed weekly reporting (form H.8), total system deposits exceeded total loans by approximately $5.8 trillion on December 21, 2022. 


Given that we expect downward AOCI pressure to alleviate over the coming quarters, coupled with banks curently having more deposits than they can efficiently deploy, we do not see significant funding stress emerging in the foreseeable future. 

Advances extended by the Federal Home Loan Banks (FHLBs) also support this position. While both Moody’s and S&P pointed to rising usage of FHLB advances as being potentially indicative of emerging funding stress, per the FHLB’s own reporting, advances across 2020 to 2021 were artificially low, and at the end of Q2 2022 were roughly inline with the level reported at the end of 2019.

Anecdotally, it appears that securities positions are being monetized via pledging as collateral for FHLB advance draws, avoiding dispositions that would crystalize unrealized losses. 

Finally, regulators vocally demonstrating awareness of the potential hidden pressure points on the banking system’s capital and liquidity positions is encouraging. While remaining vigilant, we remain sanguine on the banking system and our positioning. .


FHLBanks Office of Finance

Moody’s Investors Service

S&P Capital IQ

USBAM Research