Higher for longer keeps up pressure on fair value of bank assets

A jump in interest rates in the second quarter is set to weigh on the market value of banks' loans and securities, one of the key ingredients of the failures in March and May.

The eruption of the turmoil in March helped push rates lower by the end of the first quarter — the value of fixed-rate instruments moves inversely with rates — though bank disclosures on the fair values of assets and liabilities beyond those already reflected on balance sheets still frequently implied light adjusted capital ratios. Among publicly traded US banks with more than $100 billion of assets, the fair-value adjusted tangible common equity to tangible common assets ratio was 4.47% at March 31 in the aggregate, according to data from S&P Global Market Intelligence.

Thus, while adjusted ratios looked better at the end of the first quarter than they did at the end of 2022, they still bore the damage from an overall lift in rates over the year prior. Now, with the banking system and the economy showing resilience, and the Federal Reserve focusing on defeating persistently above-target inflation, interest rates ended the second quarter above where they were at the end of 2022. They are also higher than just before SVB Financial Group announced that it would liquidate an underwater portfolio of bonds, a move that contributed to a rapid loss of confidence in the bank.

To be sure, the overwhelming majority of banks, which generally have demonstrated far greater stability in non-maturity deposits that do not receive fair value marks, have weathered the turmoil just fine. Loans and bonds added to balance sheets when rates were low are gradually maturing and banks are building capital through earnings. Still, it could be years before fair values close most of the gap to carrying amounts on balance sheets.

Biggest banks

Adjusted tangible equity ratios at publicly traded banks with more than $100 billion of assets did increase by a median 53 basis points sequentially in the first quarter as average Treasury yields across two- to five-year maturities, which encompass much of banks' holdings, dropped 38 basis points during the period.

Still, that left four banks — Bank of America Corp., U.S. Bancorp, Truist Financial Corp. and KeyCorp — with adjusted ratios below 3%, and average Treasury yields more than retraced the drop by increasing 67 basis points during the second quarter.

BofA has long said the size of its securities holdings is a byproduct of growth in deposits relative to loans, with securities filling the gap when deposit growth is strong and loan demand is soft. The bank said it has boosted cash holdings substantially over the last couple periods as cash yields have shot up, however.

It also has enormous pools of low-cost consumer and business transaction deposit accounts that power its earnings. It has projected that its net interest income would decline roughly 2% sequentially in the second quarter to about $14.3 billion, and its sensitivity models indicate that higher interest rates, particularly at the short end of the curve, would increase its net interest income.

Mid-cap

The picture is similar for publicly traded banks with $40 billion to $100 billion of assets, where median adjusted tangible equity ratios increased 49 basis points sequentially in the first quarter, and publicly traded banks with $20 billion to $40 billion of assets, where the median increase was 43 basis points.

At Bank of Hawaii Corp., the adjusted ratio improved by 100 basis points sequentially, though it remained below zero at -0.24%.

Bank of Hawaii has emphasized its diverse deposit base, with a majority of balances covered by deposit insurance or collateralized. The $23.93 billion-asset bank also said it expects about $2.9 billion of annual paydowns and maturities from its loans and investments, creating the opportunity to redeploy into higher-yielding holdings.

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Read from AFS

Banks' accumulated other comprehensive income (AOCI), which captures changes in the market value of banks' available-for-sale (AFS) securities portfolios on balance sheets, also recovered substantially in the first quarter though it remained deeply negative.

With the second-quarter increase in Treasury rates, however, analysts at Janney Montgomery Scott estimated a mark-to-market impact on securities positions of -3.0%, assuming a duration of 4.5 years. (They noted that banks' bond portfolios may have performed better, since they contain large amounts of mortgage and municipal bonds, where prices were stronger.)

AOCI does not encompass fair value marks on items like held-to-maturity securities or loans, but the Janney analysts estimated that earnings would at least help banks power through the AFS hit and notch a median 0.5% sequential growth in tangible book value for large-cap banks, and 0.4% for mid-cap banks.