The rapid increase in interest rates has been a boon to the net interest income and earnings of U.S. banks rated by S&P Global Ratings this year, as the yields on their assets have risen faster than the cost they pay on their liabilities.

However, higher interest rates have also led to declines in the fair value of the securities banks hold on their balance sheets, weighing on their shareholders' equity even though our and U.S. regulators' capital ratios have not changed much. The unrealized losses on securities created by falling fair values, therefore, have also added somewhat to the liquidity, capital, and confidence-sensitivity risks banks face.

We view the added risks as generally manageable for rated U.S. banks, with less than 5% of those ratings assigned negative outlooks, for unrelated reasons. For most, the declines have not been outsize. We also believe rated banks largely have the capacity to hold their securities, which contain minimal credit risk, until maturity, thereby avoiding realizing interest-rate-driven losses. We believe most banks could use cash and borrow against securities to meet liquidity outflows, rather than selling securities.

That said, we will continue to focus on the magnitude of unrealized losses on securities and weigh the odds that certain banks may ultimately have to realize some of those losses. We could take negative rating actions on banks if:

• We see them as increasingly prone to confidence sensitivity issues because of low shareholders' equity;
• Their funding or liquidity unexpectedly significantly weakens, which could result from substantial deposit outflows or an increase in wholesale borrowings; or
• We see an elevated risk that they will ultimately be forced to realize losses that would eat sharply into our and regulators' measures of capital.

Below we respond to some of the key questions we receive regarding how unrealized losses in banks' securities portfolios affect our analysis.

Frequently Asked Questions

How do banks account for their investments in securities, and how do changes in the fair value of those securities affect their income and equity?

A bank must classify its investment securities into one of three categories: held to maturity (HTM), trading, or available for sale (AFS). Each category is determined largely based on management's intent and ability to hold the security to maturity:

• HTM debt securities are those that management intends and has the ability to hold until maturity.
• Trading securities are debt or equity investments that management intends to hold for short periods, with the intent of profiting from short-term price changes.
• AFS securities are debt or equity investments that are not classified as HTM or trading. For instance, a bank would mark a security as AFS if it intended to hold the security for an indefinite period but anticipated that it may sell the security if interest rates change, if it needs liquidity, or for other reasons.

Although realized gains and losses are categorized similarly across the three securities categories, the balance-sheet valuation and treatment of unrealized gains and losses vary significantly (see table 1). Notably, HTM securities are valued on the balance sheet at the amortized cost (the value of the security on the day it was designated HTM) with unrealized losses having no impact on either the income statement or balance sheet unless the securities are impaired.

In contrast, AFS securities are held on balance sheet at their fair value. Unrealized gains and losses are not realized on the income statement but are reflected in accumulated other comprehensive income (AOCI), a part of shareholders' equity. Unrealized losses on AFS securities, therefore, negatively affect shareholders' equity. Unrealized gains and losses on trading securities flow directly through the income statement.

Because banks must mark their AFS securities at fair value, there is some asymmetry in the impact of accounting standards. Rising rates not only affect the fair value of AFS securities, but also the value of all other assets and liabilities even if the accounting standards do not require those valuation changes to be reflected on the balance sheet or income statement. Fixed-rate debt and deposits, for instance, become more valuable to a bank after rates rise. If a bank marked its entire balance sheet at fair value, depending on the composition of its balance sheet, it is conceivable that its shareholders' equity would be higher, lower, or not materially changed.

Table 1

How does S&P Global Ratings treat unrealized gains and losses on securities in its analysis of bank capital adequacy?

In our primary measure of a bank's capital, our risk-adjusted capital (RAC) ratio, we neutralize the impact that unrealized losses and gains on debt securities have on shareholders' equity. That is, we do not count unrealized gains or losses on debt securities in total adjusted capital, the numerator of the RAC ratio. (However, we do not neutralize unrealized losses and gains on equity securities.)

As a result, our total adjusted capital does not reflect a benefit or loss if the fair value of debt securities changes. Counting unrealized gains and losses in total adjusted capital would create more volatility in the RAC ratio and could distort the true picture of a bank's capital adequacy in cases where unrealized gains and losses are unlikely to be realized.

Still, while we do not reflect unrealized losses and gains in total adjusted capital, we consider their magnitude, their impact on liquidity, and the probability that they could result in realized losses. We could adjust our capital assessment for a bank if we were to believe that the RAC ratio overstated or understated the strength or weakness of a bank's capital, and we could consider unrealized losses as part of that analysis. Specifically, our criteria allow for an adjustment of the capital assessment after consideration of the "relative strength or weakness demonstrated by other capital metrics."

How are unrealized gains and losses on securities treated in a bank's regulatory capital ratios?

U.S. regulators give most banks the option of neutralizing unrealized gains and losses in their calculation of regulatory capital (as we do in the RAC ratio). Nearly all those banks choose that option to eliminate that source of volatility in their capital ratios.

However, regulators do not allow the largest banks--specifically, those it considers Category I and II banks under its enhanced supervision tailoring rules--that same option. For those banks, currently the eight U.S. global systemically important banks (GSIBs) and Northern Trust Corp., unrealized gains and losses affect their regulatory capital ratios. Regulators hold those banks, because of their systemic importance, to a higher standard (as they do with certain other regulatory requirements).

How significantly has shareholders' equity dropped for banks as result of unrealized losses on securities, and how has this affected banks' tangible common equity ratios? Do you expect this to continue?

The fair value of the AFS securities held by banks insured by the Federal Deposit Insurance Corp. (FDIC) was about $321 billion, or 9%, lower than the cost basis of those securities as of Sept. 30, 2022, by our estimate. That's up from close to zero at year-end 2021. Excluding those unrealized losses, the tangible common equity of those banks would have been materially higher in the third quarter. Mostly because of those unrealized losses, the ratio of tangible common equity to tangible assets (TCE/TA) for FDIC-insured banks fell to 7.6%, from 8.5% at the end of 2021.

Chart 1

We believe this decline--along with strong loan growth and concerns about a weakening economy--has contributed to banks exercising more caution in capital management and perhaps slowed their share repurchases.

Among rated banks, TCE/TA ratios dropped a median of 80 basis points in the first three quarters of 2022, largely due to the rise in unrealized losses. Eleven rated banks had TCE/TA ratios below 5%, up from just two at the end of 2021, and the median ratio was 6.48%.

With the Federal Reserve likely to raise rates further, shareholders' equity and TCE/TA ratios could fall at least somewhat further, depending on market interest rates. While the Fed has raised rates recently, the 10-year Treasury yield was modestly lower as of mid-December compared with the end of the third quarter, perhaps easing some of the losses. Going forward, it will depend in part on whether inflation eases enough to allow the Fed to pause or eventually cut rates and how market rates behave. A reduction in rates likely would reverse some of the unrealized losses.

Investors viewed the TCE ratio as an important tool to evaluate banks' capital adequacy during the global financial crisis. At its lowest, the aggregate TCE/TA ratio of FDIC-insured banks dipped below 7% in 2008. However, there are some important differences between banks' TCE ratios today and in 2008:

• The credit quality of banks' securities portfolios today is stronger than it was in 2008. Today banks hold largely Treasuries and government and government-sponsored entity mortgage-backed securities (MBS), while in 2008, banks had a higher proportion of private-label MBS, corporate securities, and other asset-backed securities with higher credit risk.
• Banks had much higher credit risk in their loan portfolios in 2008 than today.
• Banks had much lower regulatory capital ratios in 2008 than today.
• The quality of regulatory ratios has strengthened since 2008, with more punitive risk-weighted asset charges and the deduction of unrealized losses from regulatory capital for the GSIBs.
• Banks' liquidity metrics have strengthened considerably since 2008, giving them a greater ability to hold their securities to maturity without realizing losses.

Table 2

How does a low or negative TCE ratio affect the rating on a bank?

Ordinarily, changes in the TCE/TA ratio do not affect our views of a bank's creditworthiness unless there is a similar movement in the RAC ratio or a regulatory capital ratio.

In most interest rate environments, a drop in the TCE/TA ratio triggered by unrealized losses tends to be small relative to the size of a bank's securities portfolio and liquid assets, meaning it normally doesn't materially affect liquidity (largely reflected by cash and the fair value of securities). As explained earlier, unrealized losses also do not affect regulatory capital ratios (except for at the largest banks) or the RAC.

However, recent movements in interest rates have been larger than in the past, and if unrealized losses were to grow large enough, they could affect a bank's liquidity and potentially its capital if the bank were ever forced to sell any of those securities--and therefore realize a loss--to meet a liquidity outflow. It is conceivable that a sharp drop in shareholders' equity related to unrealized losses could also raise some confidence sensitivity questions for a bank's investors and counterparties.

Therefore, in analyzing the impact of unrealized losses on a bank's creditworthiness, we focus on:

• The size of the unrealized losses relative to the bank's capital;
• The impact of the unrealized losses on liquidity;
• The odds the bank could experience material liquidity outflows (considering the nature of its funding);
• The bank's ability to meet any material liquidity outflows without selling securities and realizing losses--by utilizing cash, borrowing against its securities or other assets, or through other means; and
• The ability of the bank to earn back the unrealized loss through retained earnings, supported by the increase in net interest income that has resulted from higher rates.

While some banks we rate currently have material unrealized losses and therefore relatively low tangible shareholders' equity, we believe those banks have significant capacity to meet liquidity outflows should they arise, in large part by borrowing against their securities (whether from the Federal Home Loan Banks, the repo market, or elsewhere).

Several of the banks with TCE/TA ratios well below the median for the banks we rate have especially high levels of securities relative to their deposits and other liquidity obligations. The large proportional size of their securities portfolios in many cases has been the cause of their greater-than-peer drop in shareholders' equity. However, at the same time, those highly rated securities give them a large amount of collateral to borrow against to generate liquidity. Others with below-peer TCE/TA ratios may also have other mitigating factors including substantial preferred stock, high regulatory capital ratios, and very stable funding with a high mix of retail deposits and limited dependence on confidence-sensitive sources such as uninsured and corporate deposits. Such funding characteristics likely reduce the odds of material liquidity outflows.

That said, we believe the risk of a negative rating action could increase for banks that:

• Report further outsize increases in unrealized losses that place additional meaningful pressure on liquidity relative to peers or pose a meaningfully greater risk to capital;
• Experience liquidity outflows that force them to significantly increase their use of wholesale funding (by borrowing against securities) to meet those outflows;
• Report negative tangible equity at their subsidiary operating banks, which could disqualify them from borrowing from a Federal Home Loan Bank; or
• Are forced to sell securities and thereby realize material capital losses to meet liquidity outflows.

What percentage of the banking industry's securities portfolio has moved to HTM?

FDIC-insured banks classified about 46% of their debt securities as HTM in the third quarter of 2022, up from just over 25% at year-end 2019 and about 33% in 2021, presumably as banks have tried to blunt the impact of falling securities valuations on shareholders' equity.

Chart 2 shows the rated banks that have classified at least 10% of their securities as HTM and the percentage point change in the proportion of securities moved into HTM since year-end 2021. In general, those banks that moved a majority of their portfolios into HTM before year-end 2021 were able to avoid much of the impact of falling securities values on shareholders' equity amid rising rates.

The fair value of HTM securities held by FDIC-insured banks was 14%, or $368 billion, lower than the amortized costs of those securities as of Sept. 30, 2022. Given the HTM accounting rules, that $368 billion decline had no impact on shareholders' equity.

That's compared with a 9% decline in the value of AFS securities relative to their cost basis, which probably reflects that banks have tended to put their securities with the greatest interest rate risk in HTM, likely with the longest durations, to mitigate the impact to shareholders' equity.

Chart 2

What are S&P Global Ratings' views regarding a bank that has moved a significant amount of its securities into HTM from AFS?

In our opinion, moving securities into HTM reduces a bank's flexibility to sell or reposition these securities should the need arise. When a bank sells an HTM security, it could "taint" all of its HTM securities. That means the bank may have to reclassify its HTM securities as AFS and recognize unrealized losses in AOCI. (There are certain exceptions that allow the sale of HTM securities without tainting.) The sale could also raise qualitative concerns about risk and liquidity management.

As such, we pay particular attention to the ability of a bank to hold the securities it designates as HTM until their date of maturity. The most probable scenario for a bank selling securities that management once thought it could hold to maturity is if deposit outflows are greater than expected. Greater-than-expected deposit run-off is more likely to occur for a bank that has the following characteristics:

• Concentrated deposit base
• High percentage of commercial, brokered deposits, or uninsured deposits and a limited amount of stickier deposits
• A large buildup of deposits in a relatively short period that could reverse
• A loss in confidence in the bank, for example due to asset quality, capital, or liquidity concerns

However, as discussed above, banks could also borrow against their HTM and AFS securities to fund deposit outflows, rather than sell those securities.

How does S&P Global Ratings view a drop in the value of HTM securities?

Technically, only unrealized losses in a bank's AFS securities portfolio reduce its shareholders' equity and TCE ratio. However, we also consider how a drop in the value of HTM securities could affect equity in the unlikely event a bank were forced to reclassify those securities as AFS or to sell them. To do so, we subtract the difference in the fair value and cost basis of HTM securities from TCE and calculate a supplemental adjusted TCE/TA ratio (see table 3). Should a bank have a low TCE ratio in this context, we would closely monitor its liquidity and its ability to withstand selling securities in its HTM portfolio.

How does S&P Global Ratings weigh the benefits of rising interest rates for net interest income against the negative impact they have had on securities valuations?

While higher rates have caused the fair value of banks' securities to fall roughly $700 billion below their cost basis--cumulative for AFS and HTM--they also have sparked a sharp rise in banks' net interest income (NII). NII rose 25%, or about $137 billion on an annualized basis, in the third quarter of 2022 compared with the same quarter in 2021 for all FDIC-insured banks.

On balance, we view higher rates as beneficial to banks because of that rise in NII and despite the drop in securities values. That's because we largely don't expect banks to realize the interest-rate-driven unrealized losses on their securities (which have very little credit risk). However, we also recognize that if a bank were unexpectedly forced to realize losses on its securities, perhaps because of liquidity pressures, the benefit to NII and earnings from higher rates would very likely be insufficient to make up for the realized losses.

How do declining securities values affect a bank's liquidity?

We count both AFS and HTM in our liquidity ratios, which largely reflect cash and securities on the balance sheet. Likewise, both AFS and HTM securities count as high-quality liquid assets (HQLA) for the purposes of computing a regulatory liquidity coverage ratio, which is required for banks classified as Category I to III under the tailoring rules (generally those with assets of at least $250 billion).

However, our ratios and HQLA both reflect the fair value for the securities included in the calculation, both for AFS and HTM securities--meaning that unrealized losses lower liquidity measures. With interest rates moving higher in 2022, this has weakened all banks' liquidity, all else equal.

That said, banks' liquidity metrics still look solid (see chart 3). For instance, liquidity for the industry, as measured by liquid assets (measured roughly by cash and unpledged securities) as a percentage of total assets or as a percentage of short-term debt and deposits, has fallen somewhat this year but remains robust by historical standards.

Chart 3

How would the rating on a bank be affected if a bank were to borrow significantly against its securities to raise liquidity?

In general, for a highly rated bank, we would expect that it would maintain significant sources of secondary or tertiary liquidity, likely including securities and perhaps other assets it could use as collateral to borrow from a Federal Home Loan Bank, the Fed, or other banks or through the repo market. When a bank has little such capacity or has used up much of that capacity, limiting its flexibility to garner additional liquidity if needed, the likelihood of a negative rating action increases. In such a scenario, we would also closely monitor the bank's deposit outflow and use of funds to ensure that it has adequate liquidity to continue operations.

Table 3