The Meltdown in Regional Banks Is Systemic

Federal Reserve

The Systemic Nature of the Regional Banks’ Meltdown

The meltdown in regional banks has emerged as a systemic crisis, triggering concerns among the investors. This downturn is characterized by a series of interconnected issues plaguing regional banks, with far-reaching implications for the industry as a whole.

Note: KRE or SPDR® S&P® Regional Banking ETF, an exchange-traded fund (ETF) for regional banks, is down 40% on a year-on-year basis.

KRE price and KRE Return for the Last One Year

Regional banking exchange-traded funds, often perceived as secure investments due to their reliance on mortgages and small business loans, have experienced a complete meltdown since March.

The sudden catalyst for this situation was Silicon Valley Bank, which unexpectedly encountered a capital shortage and requires urgent support. However, the problem seems to be more systemic in nature.

Following the Great Financial Crisis of 2008, commercial banks were required to maintain a Liquidity Coverage Ratio (LCR) of over 100%. This means they must always hold sufficient High-Quality Liquid Assets (HQLA) to meet potential deposit outflows during stressful scenarios.

Interestingly, bonds, along with reserves held at the Federal Reserve, qualify as HQLA. But when regulators mandate banks to hold a significant amount of bonds, they also expose them to considerable profit and loss (P&L) volatility, which banks typically dislike.

To address this issue, regulators permit banks to categorize bonds into two accounting-friendly books: Available-For-Sale (AFS) and Held-To-Maturity (HTM). In both cases, if the value of treasuries, corporate bonds, or mortgage-backed securities (MBS) declines, the bank’s P&L does not immediately record the loss. The unrealized gains and losses of securities held in AFS affect the bank’s capital position, not its P&L.

Held to Maturity HTM Trends at US Bank
Bond Portfolio -  Meltdown In Regional Banks

The significant concern arises from bonds booked in the Held-To-Maturity (HTM) category. These bonds are reported at amortized cost, meaning that unrealized losses essentially do not appear in the banks’ financial statements.

This creates an incentive for banks to allocate a large number of bonds to this accounting category. Yet, the drawback is that when banks require liquidity, they can only sell a small portion of HTM bonds before being considered non-compliant by regulators.

The substantial extent of hidden HTM losses raises concerns. But a more critical issue lies in the diminishing liquidity (reserves) and funding (deposits). Quantitative tightening (QT) has contributed to the decline in liquidity, and US households now have the opportunity to earn a risk-free interest rate of 5% or more with less risk by purchasing Treasury bills rather than depositing money in banks.

One can argue that small banks are even more vulnerable to this dynamic, both in terms of liquidity and funding considerations.

Increasing Focus on Unrealized Losses as Deposit Outflows Escalate

Deposits fell in the banking sector as a whole in 2022, which made investors worry that some banks could have to sell bonds to meet their liquidity needs. When SVB revealed that it had sold its portfolio of assets that were available for sale for an after-tax loss of $1.8 billion, those worries came true. However, the reverse happened as depositors hurried out from the bank, withdrawing $42 billion in deposits the following day, contrary to the company’s hopes that the move and accompanying efforts to raise capital would allay investor fears.

Silicon Valley Bank suffered a failure on March 10 due to a contemporary bank run. With mounting market anxiety, Signature Bank also experienced a bank run, resulting in a loss of 20% of their deposits within a few hours. The First Republic Bank faced a similar situation. Ultimately, all three banks collapsed in 2023, triggering the regional bank crisis.

Deposits continued to tumble in the first quarter, decreasing 1.9%, according to the Federal Reserve’s H.8 data, which analyses commercial bank balances every week. Deposits at US commercial banks with domestic charters decreased by $53.25 billion in the week after the bank run at SVB. The Fed data, meanwhile, reveals significant industry-wide growth in time deposits. In contrast to a drop in non-interest-bearing deposits, higher-cost investments like CDs and borrowings are anticipated to take up even more of banks’ deposit base.


The Federal Reserve has announced separately that borrowing through its recently established Bank Term Funding Program increased to $53.67 billion from $11.94 billion the previous week. While this was happening, discount window borrowing decreased from a record high of $152.85 billion to $110.25 billion.

2023 Bank Crisis - net unrealized loss of us banks
2023 Bank Crisis – net unrealized loss of us banks

Bank Bond Portfolios Remain Submerged, Affecting Capital and Book Value

As of year-end 2022, banks’ available-for-sale (AFS) securities portfolios, which hold a significant portion of banks’ bonds and are marked to market quarterly, continued to suffer substantial unrealized losses. In the fourth quarter, financial institutions including US commercial banks, savings banks, and savings and loan associations that report GAAP financials disclosed unrealized losses of $134.10 billion in their AFS portfolios. This figure was slightly lower than the $144.53 billion reported in the previous quarter.

These unrealized losses in AFS portfolios are recorded in accumulated other comprehensive income (AOCI). While AOCI does not directly impact bank earnings, it significantly affects tangible common equity and depresses the capital metric.

Unrealized Gains Losses On Investment Securities
Unrealized Gains Losses On Investment Securities

Moreover, banks’ held-to-maturity (HTM) portfolios, which are not marked to market quarterly, experienced even greater unrealized losses by the end of 2022. Some banks, particularly larger institutions, have opted to protect substantial portions of their securities portfolios from market fluctuations by placing bonds in HTM portfolios. For banks with over $700 billion in assets, changes in AOCI would affect regulatory capital as well as tangible book value.

Among US global systemically important banks (G-SIBs) with assets exceeding $700 billion, approximately 69% of their bond portfolios were held in HTM portfolios. This percentage slightly decreased from 70% in the previous quarter but significantly increased from approximately 31% three years ago.

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Unrealized losses in HTM portfolios totaled $300.15 billion in the fourth quarter of 2022, showing a slight decrease from $322.20 billion in the preceding quarter. Some investors have started factoring in the unrealized losses embedded in banks’ HTM portfolios when assessing tangible book value, leading to adjusted, burn-down valuations for the companies. These investors believe that banks still trading below their historical price-to-tangible book values, on an adjusted basis, may present attractive opportunities and offer some protection against market turmoil, which has adversely affected many bank stocks. The investment community has also analyzed the ratio of loans plus HTM securities-to-deposits at individual banks to gauge the extent to which deposits are tied up in less liquid assets.

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