A new paper has looked at the likely extent of losses from US banks’ bond portfolios and the answer is a bit shocking. 

What they’re looking at is losses on bonds in the “held to maturity” bucket, ie the ones banks don’t have to write down in their financial statements when the bonds’ market value goes down.

Authors Erica Jiang, Gregor Matvos, Tomasz Piskorski, and Amit Seru estimate aggregate losses from these bonds for US banks are $2.2 trillion. This is a big number so here is some context: the authors estimate these losses cause bank assets to fall by an average of 10 per cent, with the bottom 5th percentile experiencing a decline of approximately 20 per cent.

A ten per cent fall is significant. US banks have, on average, only nine per cent more assets than their liabilities. According to the paper, “2,315 banks accounting for $11 trillion of aggregate assets have negative capitalization.” 2,315 out of a total of more than 4,800.

Negative capitalisation in nearly half of America’s banks is bad. But it doesn’t mean certain disaster. Banks can muddle through these sorts of situations.

The problem is the potential for bank runs. Negative capitalisation is bad in that it could get people agitated. That’s when they start pulling their money out and things get messy. 

The paper is more optimistic on that point. The most extraordinary thing about SVB wasn’t its mark-to-market bond exposure, but the degree to which it was funded by uninsured depositors who had every reason to pull their money out at the first sign of trouble. SVB was more heavily funded by uninsured depositors than 99 per cent of banks. Where SVB was 80 per cent funded by uninsured deposits and debt, the median bank is 27 per cent funded with it.

The authors also point out that their calculation of banks’ exposure on held-to-maturity bonds doesn’t account for interest rate hedges. It is standard practice in banking to hedge interest rate risk, even if SVB didn’t bother. So $2.2 trillion is an upper bound. 

What about Europe? The European Banking Association shares data on European bank assets. According to the EBA, European banks hold €1.27 trillion of securities at amortised cost (which means they’re not marked to market). This amounts to 4.7 per cent of total European bank assets.

Jiang, Matvos, Piskorski, and Seru argue said marked-to-market bank assets have declined by an average of 10 per cent across all US banks. Applying that to European holdings of HTM securities gives €1.14 trillion, a decline of 0.5 per cent of all assets.

What accounts for the difference? US banks hold 25.2 per cent of total assets in the form of securities. The EBA says 8.8 per cent of European banks’ assets are in the form of securities, though that number might reach 20.7 if “assets held for trading” also fall into the same bucket. 

So it looks like European banks hold fewer securities than US banks, and a greater proportion of them are marked to market. 

It’s a safer place to be. But then, Credit Suisse was well-capitalised, and that didn’t stop depositors from pulling their funds. What I said about bank capital cuts both ways — a poorly capitalised bank can muddle through in the absence of panic, but a well-capitalised one can be sucked under in its presence.

Funny business with deposits

This drama reminds me of an event I attended last year for the launch of the digital euro project. Some of its heavy hitters were there: executive board members Philip Lane and Fabio Panetta, along with EU Commissioner Mairead McGuinness. 

The event was in May 2022. It was a different time for central banks. There was less worry about inflation and bank runs, and more about the threat from cryptocurrencies.

The ECB is exploring a digital currency because it doesn’t want to be cut out of the financial system. Right now the only object that can be freely traded for goods and services in the eurozone is the euro. The nightmare scenario for the ECB is a technology company launching a digital currency, and it gets widely adopted. That would leave the ECB impotent. It wouldn’t be able to cool the economy down by raising interest rates or vice versa. 

So the ECB is looking into creating a Digital currency for ordinary people before someone else does it. It’s envisioned the currency will be easy to use, will settle instantaneously, will be accepted universally and will be risk-free. 

The problem with this idea, as I mentioned at the time, is that it’s too good. A digital euro would be like a normal bank account — but better in every way. It would be easier to use, faster, and crucially, less risky. 

The risk factor didn’t seem salient last Spring, but it does now. In times of financial stability, funds would flow directly out of banks and into digital euro accounts.

In a speech at the time, governor Panetta said the ECB faced the risk of “being “too successful” and crowding out private payment solutions and financial intermediation.

He said the ECB was considering throwing some sand in the gearbox of the digital euro to make it good enough to repel competitors, but not so good it ruins the banks. 

Having the central bank control bank deposits might sound like a radical idea but it might be where we’re headed. The alternative might be worse.

For example this month, in response to the mini-financial crisis, US regulators have bailed out uninsured depositors. This has happened very consistently in recent financial crises. The Cypriot depositors are the only counter-example that comes to mind. 

Depositors and bankers must have gotten the message by now: depositors will always be made whole. That fires the starting pistol for banks to take lots of risk. More risk allows it to generate more returns and in turn offer higher interest rates to depositors, with whose capital it can take more risk and so on.

In this world, it’s left to regulators to ensure banks don’t take too much risk. This is a hard job and regulators’ track record isn’t good. So maybe full-on digital currencies will be part of the answer. 

P.s. Last week I specifically said “It won’t be bonds that get us”, arguing that it would be strange for a financial crisis to be precipitated by assets whose value tends to go up during a financial crisis. Might be smart to walk that one back…