Banks increased their exposure to the short end of the yield curve in the fourth quarter of 2022 and likely will be even more conservative when investing in the future given liquidity pressures in the industry.

Sharp increases in interest rates have left bank bond portfolios deeply underwater, particularly at institutions that reached further out on the yield curve to pick up additional income when rates were near historic lows. Those decisions have left banks with less access to liquidity and with securities with below-market rates at a time when funding is far more expensive. Consequently, banks will likely be even more cautious to put new cash to work in the bond market in the coming quarters.

In the fourth quarter of 2022, bank securities fell 0.7% from the prior quarter, falling to 24.9% of assets from 25.1% in the prior quarter, according to S&P Global Market Intelligence data.

As liquidity pressures grow, banks keeping powder dry

Deeply underwater bond portfolios have reduced banks' liquidity levers at a time when deposit outflows have accelerated and funding costs are rising. The investment community is now heavily scrutinizing institutions with outsized bond portfolios and adjusting tangible book values for implied losses on bonds, including those in held-to-maturity security portfolios. Those portfolios are not marked to market on a quarterly basis but have come under pressure due to the notable increase in interest rates over the last year.

While total securities dipped modestly in the fourth quarter of 2022, banks maintained their exposure to the long end of the yield curve. Bonds expected to reprice or mature in more than 15 years held fairly steady at 33.8% of bank-held securities in the fourth quarter of 2022, compared to 33.7% in the prior quarter and 34.7% in the year-ago period.

Banks deploy more cash in shorter-term investments

Banks' relative exposure to the short end of the yield curve continued to rise in the period. Securities expected to mature or reprice in less than three years rose more than 2% in the fourth quarter of 2022 from the prior year. Shorter-term securities grew to 24.6% of total securities from 24.0% in the prior quarter.

It is unlikely banks will grow their securities portfolios considerably at this point in the rate cycle and instead likely will allocate more funds to the shorter end of the yield curve as bank managers adjust to elevated deposit outflows and even greater pressures on liquidity, which have grown in the aftermath of the failures of Silicon Valley Bank and Signature Bank.

The Federal Reserve's H.8 data, which tracks commercial bank balances on a weekly basis, shows that deposits continued to decline in the first quarter, falling 2.8% through the week ended March 22. Meanwhile, securities have experienced similar declines, also dropping 2.8% during the same period.

As banks look to preserve liquidity, institutions likely will remain hesitant to grow their securities portfolios considerably. Given the pressures in the marketplace, bank managers could put a premium on shorter-term, liquid paper when making future investment decisions and worry less about earnings stream from their bond portfolios.