As bond portfolios moved deeply underwater, U.S. banks were even more hesitant to deploy cash in their securities in the third quarter.

Further increases in interest rates have weighed heavily on the value of most bonds that banks own. As unrealized losses have grown in banks' securities portfolios, institutions have faced deposit outflows, making them even more cautious to put new cash to work in the bond market. Bank securities fell 3.7% from the prior quarter, falling to 25.1% of assets from 25.9% in the prior quarter, according to S&P Global Market Intelligence data.

More cautious investment approach as liquidity pressures rise

Significant tightening of monetary policy by the Federal Reserve has raised concerns over banks' liquidity in the investment and regulatory communities as deposits have declined and loans continue to grow at a healthy pace. Some investors and regulators have questioned whether banks would have to sell underwater bonds to meet their liquidity needs and banks, seemingly aware of those fears, have slowed new investments in the bond market considerably.

The Fed increased the target fed funds rate 300 basis points through a series of rate hikes between mid-March and late September. The central bank hiked rates another 75 basis points in November and is expected to raise rates another 50 basis points Dec. 14. Intermediate and longer-term rates moved ahead of rate hikes, with the average yields on the 2-year, 3-year and 5-year Treasurys increasing close to 200 basis points or more since the tightening cycle began.

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Banks allocated less cash toward the long end of the yield curve in the third quarter since those securities could face additional pressure if rates rose further. Bonds expected to reprice or mature in more than 15 years nearly fell to 33.7% of bank-held securities in the third quarter from 33.8% in the prior quarter and 35.7% in the year-ago period.

Banks deploy more cash in shorter-term investments

While total securities declined in the third quarter, banks' relative exposure to the short end of the yield curve rose in the period. Securities expected to mature or reprice in less than three years declined 1% in the third quarter from the prior period. But the positions represented larger portions of banks' securities portfolios, with shorter-term securities climbing to 24.0% of total securities from 23.4% in the prior quarter.

Banks' investment approach seems unlikely to change in the near term as liquidity concerns remain at the forefront of bank managers' minds. The Fed's H.8 data, which tracks commercial bank balances on a weekly basis, shows that securities have continued to decline in the fourth quarter, falling nearly 1% from Sept. 28 through the week ended Nov. 30.