Fed’s Regulations on Securities Losses Fail to Capture the Risk of Rising Interest Rates and the Impact on Tier I Capital

Summary of Bank Failures

Review of Silicon Valley Bank, Signature Bank and First Republic Bank by the Fed revealed management relied too heavily on uninsured deposits and invested too much in long-term bonds that declined in value as interest rates climbed.1

Relaxed rules and regulatory easing allowed for these banks to go unchecked. Management either didn’t understand the significance of these liquidity issues or ignored them, until depositors at these banks recognized the losses exceeded the capital and fled, triggering a run that could only be stopped by government intervention.1

Recent History of Fed Regulations on Unrealized Losses of Securities Held for Sale

Accumulated Other Comprehensive Income (AOCI) or unrealized losses on securities held for sale net of hedges were allowed to be included for smaller banks (with assets under $100 billion) in Tier I capital upon a bank’s election as of January 1, 2015. In 2019, about 30 larger banks with assets between $100 billion and $700 were extended the option for calculation of Tier I capital.

The Loophole that Masked the Losses on Silicon Valley Bank’s Securities Held for Sale

The Federal Reserve is considering changing an exemption that allows some banks to boost the amount of Tier I capital. Led by Michael Barr, vice chairman of the Fed for supervision, it will institute a series of tougher rules to come after SVB’s failure. For example, Barr noted SVB’s capital levels included unrealized loss on securities available for sale.

Under post-2008 financial crisis rules, banks were directed to include unrealized gains and losses on such securities in their capital ratios. In 2015, however, smaller regional banks were allowed to skip this requirement based on the argument that it would introduce too much volatility into their capital metrics. Subsequently, these banks were allowed to add the amount of unrealized losses on securities available for sale net of hedges (AOCI) in calculating their Tier I capital. In 2019, thirty large U.S. regional banks earned an exemption too.

As of the fourth quarter of 2022 bank financial data, a small number of banks that elected to add AOCI to Tier I capital reported negative Tier I before such addition. Another modest number of banks had Tier I capital ratios positive after net of this addition, but less than the 5% minimum required to be well capitalized.

While regulators are considering extending tighter restrictions to only about 30 banks with between $100 billion and $700 billion in assets, IDC Financial Publishing (IDCFP) will reduce ranks of financial ratios on banks with Tier I capital net of AOCI below 5%. The regulations in 2015 allowed the addition of AOCI to limit volatility on Tier I capital, but not to substitute AOCI for negative Tier I or levels below 5%. IDCFP will implement a rank reduction to reflect these risks listed above in the release of first quarter 2023 data in mid-May.

Losses on Securities Held to Maturity Add Risk to a Bank, Given Uninsured Deposits and Borrowings Are Excessive

The rapid rise in the Fed funds rate in 2022 and 2023 creates an additional risk of reducing the value of securities held to maturity given liquidity problems. IDCFP defines liquidity as the amount of uninsured deposits and the total borrowings as a percent of the market value of assets available for liquidation. Assets available for liquidation include interest-bearing balances, securities at market value, net Fed funds, loans held for sale, and net trading assets.

Given uninsured deposits and borrowings exceed the market value of assets available for liquidation, that excessive amount times the ratio of unrealizes losses on securities held to maturity to tangible common equity capital defines the risk in terms of the amount of IDCFP’s rank reduction.

Based on fourth quarter 2022 data, the liquidity rank reduction would have reduced the IDCFP rank by 158 in the case of Silicon Valley Bank and by 151 in First Republic Bank. Beginning with the first quarter of 2023 rank financial reports, published in mid-May, IDCFP will reduce the rank of financial ratios by the liquidity risk outlined above for a modest number of banks with excessive risks to capital.

“One way of making banks safer for the whole economy is to ensure a larger capital buffer,” - David Kass, finance professor at the University of Maryland’s Robert H Smith School of Business.

1 - If the Banking Crisis Offers One Lesson, Let It Be This, Bloomberg Opinion, 5/1/2023

To view all our products and services please visit our website www.idcfp.com. For more information on banks with brokered CDs outstanding, and the amount of these CDs, or for a copy of this article, please contact us at 800-525-5457 or info@idcfp.com.

John E Rickmeier, CFA

Robin Rickmeier
Marketing Director