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The surge in 10-year U.S. Treasury yields will likely lead to an increase in unrealized losses on U.S. banks' balance sheets, but the Federal Reserve's emergency actions earlier this year and banks' efforts to strengthen their balance sheets have helped limit the associated risks.

What We're Watching

The rout in U.S. Treasuries—with tumbling prices sending the yield on 10-year notes to a 16-year high just below 5% in recent weeks—could have wide-ranging effects on other financial markets, the broader economy, and credit. For instance, U.S. banks could see an increase in unrealized losses on their balance sheets.

In our view, the steep price drop on the 10-year note has likely been driven in part by an increase in issuance from the Treasury Department looking to plug record budget deficits. Meanwhile, after a decade of quantitative easing that saw the Federal Reserve buy trillions of dollars in government debt in the wake of the Global Financial Crisis to push real interest rates below 0%, the central bank is now allowing some of its holdings to run off as it continues to tighten monetary policy.

This comes as policymakers have lifted the federal funds target rate to 5.25%-5.5% from effectively zero, in just a year and a half. S&P Global Ratings Economics anticipates the central bank will raise its policy rate again this year and keep it there until at least mid-2024 in a "higher-for-longer" environment.

What We Think And Why

U.S. banks will likely see a further rise in unrealized losses when they post third-quarter results starting later this week, on top of the increase we saw in the second quarter. During the long period of accommodative monetary policy and fiscal support that fueled significant deposit growth, U.S. banks added substantially to their securities portfolios, in large part by buying mortgage-backed securities (MBS) guaranteed by Fannie Mae and Freddie Mac, and Treasuries. The subsequent sharp tightening of Fed monetary policy and the associated rise in market interest rates has since caused the fair value of those securities to fall.

In our view, banks with a combination of heavy unrealized losses and funding concentrations face the highest risk of a potential loss of depositor confidence and deposit outflows. But after lowering ratings on nine banks, revising outlooks on five banks to negative (excluding those we have downgraded), and revising outlooks to stable from positive on four others this year, we do not expect widespread further negative rating actions. We view the risks associated with any increase in unrealized losses as generally manageable for the U.S. banks we rate.

We believe our rated banks, which are among the largest in the industry, generally have far less significant combinations of unrealized losses and depositor concentrations than those that failed in March and April. They've also strengthened their balance sheets, including by limiting shareholder payouts, slowing loan growth, adding contingent liquidity, and paying more to attract and retain deposits.

We think banks we rate can, generally, hold their securities until maturity, thereby avoiding realizing rate-driven losses. That's partially because the Fed's emergency measures earlier this year enhanced banks' access to liquidity and lowered the odds they will have to sell or borrow against their securities. Through the Fed's Bank Term Funding Program, banks can borrow at a 100% advance rate against the par value of their securities. In our view, the Fed's actions significantly helped the industry find a greater degree of stability.

Naturally, the path of unrealized losses depends on market interest rates. If medium- to long-term rates rise materially, unrealized losses could grow further. A drop in those rates would lead to lower unrealized losses. As securities move toward maturity, unrealized losses will also amortize down.

What Could Go Wrong

Banks had already grown more conservative in their lending in the wake of recent sector turbulence. We expect banks will remain cautious as they look to bolster capital ratios to support confidence and prepare for a likely tightening of capital requirements.

Regulators have proposed to update the capital requirements for banks with more than $100 billion in assets to align them with the final Basel 3 standards, set to be phased in starting in July 2025. As part of that, all large banks would have to account for unrealized losses on available-for-sale (AFS) securities in their capital ratios. Currently, only the eight global systemically important banks and the next largest category of banks are required to do so.

We also believe counterparties and investors may consider how banks' capital ratios would look if they included unrealized losses not only on AFS securities but on held-to-maturity securities and, perhaps, loans. So, in our view, banks will likely look to conserve capital in part through restrained loan growth.

Banks with a material level of fixed-rate, long-duration securities could also face greater pressure on their net interest margins (NIMs) than other banks. Deposit costs have been rising sharply in recent quarters, and NIMs have begun to contract for many banks, weighing on profitability. A continued rise in deposit costs would add to this pressure.

Writers: Joe Maguire and Molly Mintz