Banks across much of the world have seen a boost to their net interest income, because asset yields have risen faster than the cost of their liabilities. But it is not all good news. Higher rates have also resulted in a decline in the value of fair-valued financial assets that banks hold on their balance sheets (see Related Research, below). In some cases, as illustrated by the recent stress experienced by Silicon Valley Bank (SVB), it can contribute to a material deterioration in a bank's credit profile (see "Silicon Valley Bank Rating Lowered To 'D' And SVB Financial Group Rating Lowered To 'CC'; Ratings Subsequently Withdrawn," published March 10, 2023).

S&P Global Ratings thinks that the risk of significant unrealized losses materializing on a portfolio of high-quality liquid securities is typically contained for the banks we rate, but could be triggered for some banks with concentrated business models, or with more vulnerable funding or liquidity profiles, including more aggressive asset/liability management practices.

Unless offset by regulatory intervention, including availability of access to central bank funding, unrealized losses can materialize if a bank looks to sell its securities portfolio because it does not have adequate contingent sources of liquidity or has wider asset/liability mismatches. A bank's attempts to strategically reposition its asset-sensitivity by selling a portion of its long-duration securities at a loss and reinvesting those proceeds in shorter-duration assets may compromise market confidence, further accelerating a run on deposits. A confluence of some of these factors led to the sudden failure of SVB. (We have highlighted some metrics we are looking at to gauge which U.S. banks may be more vulnerable to such market concerns: see "The Fed's Plan For U.S. Banks Should Reduce Contagion Risk," published March 13, 2023.)

Unrealized Losses In Bank Financial Reporting

For debt securities reported at fair value, there are two ways in which fair value losses are treated in banks' financial reporting:

• Realized losses: Fair value losses arising from financial assets held for trading are realized directly in net income, and consequently into shareholders' equity, regulatory capital, and our measure of bank capital, the risk-adjusted capital (RAC) ratio. And while higher rates have resulted in such fair value losses (rather than gains) being realized in income, across much of the world the extent of these losses has been far smaller than the boost to banks' net interest income line.
• Unrealized losses: Fair value losses arising from financial assets held on the balance sheet at fair value for purposes other than trading--such as liquidity management--are unrealized. That is, they are not part of net income, but instead are recognized in shareholders' equity through other comprehensive income.

In both cases, fair value losses directly affect shareholders' equity, and may add to liquidity, capital, and confidence-sensitivity risks that banks face, but unrealized losses are less directly visible in bank reporting.

For debt securities reported at amortized cost, unsurprisingly there is no adjustment made in the financial statements to reflect fair value movements. And outside of reporting under U.S. accounting standards (U.S. generally accepted accounting principles, or GAAP), the disclosure of fair value movements for amortized cost debt securities is very limited. That said, in practice, it would typically take an acute liquidity crisis to force the materialization of unrealized losses on amortized cost securities. Even then, we expect banks would first attempt to pledge the assets to obtain cash, for example with a central bank, and only sell these assets (and therefore realize the market value loss) as a last resort. That is why, for amortized cost debt securities, we generally view as remote the likelihood of fair value losses (or gains), becoming realized, particularly where a bank's asset-liability structure is well matched by maturity.

Unrealized Losses In Bank Capital

The regulatory capital treatment of unrealized losses differs for banks across the world. In the U.S., most banks are allowed to neutralize unrealized losses (or gains) from their regulatory capital. In other words, unrealized losses do not directly affect their Common Equity Tier 1 (CET1) capital ratios. The largest U.S. banks--that is, the eight U.S. global systemically important banks and Northern Trust Corp.--are held to a stricter standard: unrealized losses must be included in their CET1 ratios, and therefore lead to lower ratios when unrealized losses rise.

In Europe, capital requirements do allow for some prudential filters aimed at smoothing out the impact of selected market movements on regulatory capital. This includes, for example, unrealized gains or losses from cash flow hedges; this is on the basis that the hedged items themselves are not recognized at fair value on the balance sheet. But outside these relatively limited filters, the rules mandate that unrealized losses must be included in CET1 in full for all banks, regardless of their size.

In Japan, the rise of domestic short-term interest rates has been limited. As a result, unlike banks in the U.S. and Europe, Japanese banks have not enjoyed an interest-rate-driven large boost to net interest margins, although they have still suffered from unrealized fair value losses on their foreign bond holdings. Also, in Japan's case, the interest rate sensitivity of banks that focus on securities investment rather than lending (such as Norinchukin Bank, Japan Post Bank, and Shinkin Central Bank) is extremely high. We recognize this risk of high interest rate sensitivity in our ratings. Specifically, our moderate assessment of the risk positions on Norinchukin Bank and Japan Post Bank constrains the issuer credit ratings. For Shinkin Central Bank, which we assess as having an adequate risk position, sensitivity to interest rate risk is a key downside risk that could negatively affect the ratings. We continue to monitor bond prices--which can fluctuate widely and change rapidly--to assess whether they could have a more significant impact than we already factor into these ratings.

Our Expectations For Bank Ratings

While regulatory capital approaches differ for unrealized losses, our primary measure of a bank's capital is our RAC ratio. In the RAC ratio, we neutralize the impact of unrealized losses and gains from debt securities and cash flow hedges. In our view, if the RAC included unrealized gains and losses, the RAC ratio would become more volatile, which could distort the true picture of a bank's capital adequacy when we do not expect the bank to realize those gains and losses. Indeed, in most cases, we do not expect unrealized losses (or gains) from debt securities to become realized to any material extent, because the securities--generally government bonds or similar low-credit risk securities--tend to be held to maturity or sold close to their maturity, at which point they are close to their par value.

Nevertheless, we do consider the magnitude of any unrealized fair value losses (or gains) and the likelihood that losses could become realized. That likelihood can be higher if the maturity profile of the underlying debt securities lengthens. If we think that the RAC ratio for a specific bank is not an accurate reflection of the strength or weakness of that bank's capital, we could adjust our capital assessment for that bank. For example, we may reflect unrealized losses in RAC where we believe such losses reflect a sustainable deterioration in credit risk, and we may also increase our focus on other capital metrics when it comes to scoring capital and earnings for such a bank. And we use our assessment of a bank's risk position to refine our view of a specific bank's risk appetite, exposures, or concentrations beyond what is captured in the headline capital metrics.

At this stage, we view the risks from unrealized losses as manageable for the banks we rate, thanks in large part to healthy liquidity and capital, helped further in many cases by the uptick in 2022 earnings from rising rates. We think that most banks have the capacity to hold their (nontrading) fair-valued assets to maturity, and in doing so neutralize the impact of unrealized losses over time.

Still, while we see the risks as broadly manageable at present, that may not remain the case. We continue to monitor the magnitude of unrealized losses and consider factors that may result in banks having to realize such losses. This may arise, for example, where a bank is increasingly prone to confidence sensitivity concerns because of falling shareholder equity, or significantly weaker funding and liquidity arising from deposit outflows or higher wholesale borrowing.

Banks may be also affected by their exposure, direct or indirect, to counterparties that have themselves suffered from the decline in the fair value of financial assets. For example, nonbank financial institutions (NBFIs) often hold significant portfolios of debt securities and derivatives and some operate with elevated leverage. These NBFIs would be hit by fair value declines; for example, through additional margin calls that may strain their liquidity. Banks tend to have a limited direct exposure to NBFIs (see "When Rates Rise: Risks To Global Banks Could Emerge From The Shadows," published Feb. 16, 2023). But indirect contagion risks--for example, from the failure or rapid deleveraging of one or more large NBFIs--could spell trouble for the broader financial sector in the absence of public intervention and central bank access.

Related Research

U.S.

• Rated U.S. Banks Haven't Seen Widespread Deposit Outflows But Uncertainty Continues, March 14, 2023
• The Fed's Plan For U.S. Banks Should Reduce Contagion Risk, March 13, 2023
• Silicon Valley Bank Rating Lowered To 'D' And SVB Financial Group Rating Lowered To 'CC'; Ratings Subsequently Withdrawn, March 10, 2023
• How Unrealized Losses On Securities Affect U.S. Bank Ratings, Dec. 13, 2022

Europe

• European Banks See Limited Contagion Risk From SVB, March 14, 2023
• Will Unrealized Losses On Financial Assets Affect Ratings On European Banks? , Jan. 19, 2023

Asia-Pacific

• SVB Default And Asia-Pacific Banks: Secondary Effects Are The X-Factor, March 16, 2023
• Japan Banking Outlook 2023: The Impact Of Raising Interest Rates, Jan. 17, 2023
• Bulletin: Norinchukin Bank Capital Hit Exposes Interest Rate Risk, Nov. 18, 2022
• When Rates Rise: Among Japanese Banks, Beware Of Bondholdings, Aug. 22, 2022

Latin America

• Latin American Banks To Face Secondary Effects Of SVB Turmoil, March 15, 2023