"Losses" are approaching $700 billion! With the surge in US bond yields, is another banking crisis looming in the United States?

As the "anchor of major asset prices" hits a record high, the pressure on the US banking industry due to interest rates has increased dramatically.

Recently, several Wall Street banks, including Goldman Sachs and JPMorgan Chase, have issued warnings about the risks of high interest rates. Steven Zeng, a strategist at Deutsche Bank, also pointed out in a report that if interest rates continue to rise, a banking crisis is likely to recur.

Zeng stated that the recent surge in interest rates has undoubtedly expanded the unrealized losses of banks' bond investment portfolios, which was also a catalyst for the regional bank failures earlier this year.

According to data from the Federal Deposit Insurance Corporation (FDIC), Deutsche Bank estimates that the unrealized losses of the US banking industry in the third quarter of this year are likely to exceed $700 billion, surpassing the peak of $689.9 billion in the third quarter of 2022:

The 10-year Treasury yield has risen by more than 70 basis points this quarter. In addition, in the second quarter, the US banking industry held $54.36 trillion in debt securities, mainly institutional mortgage loans and government bonds.

If we assume that the key rate duration of the 10-year Treasury is 3.5, and everything else remains unchanged, these securities will lose $140 billion in value this quarter.

Zeng concluded that although the systemic solvency risk of the US banking industry is low, the decrease in securities valuation may put pressure on banks' capital adequacy ratios, which could reduce their willingness to lend and decrease credit flow in the economy.

Of course, through this mechanism, the rise in yields will also continue to drive inflation and economic growth towards the Federal Reserve's target.

As previously mentioned by Wall Street News, the current financial conditions are even tighter than before. The banking industry now has the Federal Reserve's BTFP policy tool as a backstop, so there is no immediate risk. However, after six months, the BTFP mechanism will expire. The negative impact of high interest rates on the financial markets may further transmit in the future.

Sarah Cha, a trader at Goldman Sachs, mentioned the banking crisis earlier this year in her latest daily briefing:

Yesterday, we witnessed a "perfect storm" where long-term yields rose, credit spreads widened, and the stock market fell once again when we woke up in the morning. I believe that many people have come to the realization that when these three things (=risk aversion) become a reality, financial stocks are not "safe" anymore. Therefore, Goldman Sachs' trading department has refocused a lot of attention on banks, but not for good reasons.

Is the market expecting another March 2023, or something else? While much of the recent discussion has revolved around the securities portfolio losses (HTM + AFS) and adjusted capital ratios, we believe that so far, most of the informed discussions are not about the existing risks, but about the ongoing liquidity pressures and erosion of profitability. If deposit pricing (i.e., interest rates) continues to rise, banks will pay more attention to optimizing their balance sheets/selling securities and loans.

Goldman Sachs points out that as capital pressures increase, banks have been sacrificing their profits to improve capital outcomes. Since the third quarter of 22, the four largest banks in the United States have purchased a large number of credit default swaps (CDS) every quarter to meet better regulatory capital treatment standards. The amount of CDS purchased has increased by 47% compared to the same period, while the securities balance has decreased.

As the market attempts to stress test these banks in the context of higher interest rates, banks with adjusted immediate capital below ~7% are the ones that the market seems to be most concerned about in terms of downward movement, those that may have announced victory early or pushed for RWA (risk-weighted assets) optimization and cost reduction.

In addition, although the stock market has not yet reacted, the default swaps of major US banks have expanded dramatically.