Reviewing market impacts to the investment portfolio and reviewing current policies

Henry Kwan, SVP & Deputy TreasurerEast West Bank

Below is an insight into what can be expected from Henry’s participation at CeFPro’s Balance Sheet Management USA Congress.

The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.

2023 is disheartening to me as I have seen the collapse of Silicon Valley Bank and First Republic Bank in my neighborhood. While the main reasons for their failures are deposit runs due to sizeable uninsured deposits and elevated deposit concentration, ineffective investment portfolio management under unprecedented interest rate movements catalyzed their downfalls.

The primary function of the investment portfolio for a bank is to maintain its liquidity needs while generating a steady stream of income. It is also a tool for interest rate risk management, capital preservation, and risk diversification. There is often a trade-off between interest rate risk and investment return. Generally, increasing interest rate risk in the portfolio by adding longer-dated fixed-rate investments will increase the overall portfolio return. But, simultaneously, the portfolio with a higher interest rate risk profile will suffer from higher valuation reductions when the interest rate moves higher. After the pandemic in 2020, we observed a surge in deposits in the banking system. However, the loan originations at banks could not catch up with the increase in deposits, so excess cash has been built up. During that time, the low-interest rate environment is at the lowest level in history. Instead of keeping the excess cash at the Fed earning merely 10bps, many banks executed the investment strategy to increase their securities holdings and take more interest rate risk to enhance their incomes. However, do they have a clear picture of the potential impact of this strategy? Let’s take a deeper look at the following.

Interest rate risk on a securities portfolio is the risk of change in market values of the securities holdings held in the portfolio due to the movement in the prevailing interest rates. When interest rates increase, the securities portfolio’s market value generally will decrease. However, the impact on the banks varies depending on the categorization of banking organization, by the size of the bank and the classification of securities under ASC 320-10-25.

In the following table, I illustrated the different outcomes of the securities portfolio with a 20% unrealized loss under an increasing interest rate environment at a hypothetical bank under four different scenarios as compared with the base scenario:

  1. Base scenario: no unrealized loss; the entire securities portfolio is under Available for Sale (AFS)
  2. Scenario 1a: 20% unrealized loss in the securities portfolio; AOCI is opted out, which applies to small Banks with asset size below $100 bln; the entire securities portfolio is under AFS
  3. Scenario 1b: 20% unrealized loss in the securities portfolio; AOCI is not opted out, which applies to large Banks with asset size at $700 bln or above (Category I and II post-EGRRCPA); Entire securities portfolio is under AFS
  4. Scenario 2a: 20% unrealized loss in the securities portfolio; AOCI is opted out; half of the securities portfolio is under Held to maturity (HTM), and the other half in AFS
  5. Scenario 2b: AOCI is not opted out; half of the securities portfolio is under HTM, and the other half in AFS



The key takeaways of the above illustration on securities subject to valuation depreciation when interest rates increases are:

  1. AOCI opt-out on AFS securities will eliminate the impact on the regulatory capital while the effect on tangible equity remains;
  2. HTM securities can shield from the impact on regulatory capital and tangible equity.

Nevertheless, there is no doubt that the market value depreciation of banks’ securities portfolio under an increasing interest rate environment will lead to liquidity deterioration due to the reduction in collaterals for borrowing capacity. As the Fed aggressively increased the Fed Funds Target rate by 525 basis points since March 2022, a portfolio with five years duration would experience 20-25% of market value depreciation, which impacts the borrowing capacity from securities in the same manner.

As banks generally hold more securities under AFS than under HTM, we also observed a reduction in the banking industry’s tangible equity and tangible capital ratio during the same period. Those banks, particularly community banks, having large securities portfolios with a large percentage of their securities portfolio designated AFS, as opposed to HTM, suffered a significant impact in their tangible capital ratio. At the end of 2021, only a handful of community banks had an equity capital ratio below 5%. As of the third quarter of 2022, that number has increased to around 350, with some banks posting negative tangible capital ratios. Besides shrinking borrowing capacity, these banks are facing additional funding challenges: Federal Home Loan Banks (FHLBs) are not permitted to extend new advances to banks with negative tangible equity, and outstanding FHLB loans may not be renewed beyond thirty days unless borrowers’ primary regulators obtain waivers. In a worst-case scenario, a bank might have to sell “underwater” bonds to raise cash, thus realizing losses and reducing regulatory capital without the prior AOCI opt-out. Selling securities at a loss was an action taken by Silicon Valley Bank. It became one of the catalysts for the unprecedented deposit runoff and, in the end, the failure of the Bank.

The banking crisis in the first half of 2023 is a wake-up call for banks to review their current policies and monitoring procedures concerning securities portfolios. Based on the experience during the banking crisis, banks can conduct a gap analysis to locate missing or inadequate risk monitoring. Banks could consider potential enhancements in the following areas:

  1. Developing comprehensive monitoring frameworks: Banks should closely align their risk appetites with strategy execution so the check and balance function can work effectively. The monitoring framework should extend to both business-as-usual and stress scenarios as well. Also, banks should revisit metrics in assessing their key risks to ensure they are appropriately managed. Omitting key risks could significantly impact liquidity and capital, not to mention regulatory scrutiny. For example, getting complacency at the stable regulatory capital level with the AOCI opt-out could lead to excessive interest risk-taking in the securities portfolio and overlook the reduction of liquidity resources and the valuation depreciation under an increasing interest rate environment. This ignorance could deplete the bank’s liquidity and end up in failure.
  2. Improving the sophistication of risk analytics: The risk environment is constantly evolving. News and information now propagate instantaneously; electronic transactions can be done much faster than in the past. It requires Banks to establish better risk intelligence to manage and react to risk promptly. Banks should adopt more advanced technology using digital risk analytics tools to measure, quantify, and predict risk. More sophisticated risk analytics can create better data-driven insights and increase the agility of risk monitoring and risk mitigation.

While the year 2023 is disheartening to me, it is an excellent reminder for banks to recognize the risk associated with the securities portfolio once again after the great financial crisis. It is time to revisit the current policy for the securities portfolio and enhance the risk monitoring framework to avoid following the path of Silicon Valley Bank and First Republic Bank