Rising interest rates may be good for a bank’s revenue stream, but they have the ability to wreak havoc on the balance sheet and, thus, shareholder equity.
A bank by the simplest definition is a holder and lender of deposits. When a buildup of deposits occurs unaccompanied by a similar growth in loans, banks put their spare cash to work in temporary investments until it’s needed to fund higher-yielding assets — like loans to businesses.
This is good because liquidity that would normally be earning zero dollars in cash can earn a little money — but is it worth the extra risk?
Accounting rules dictate these investments be reported at fair value, which declines when interest rates rise. This is fair because the assets are worth less than ones sold at the higher prevailing rates, but the fair-value adjustment isn’t necessarily a loss that the bank is going to realize.
As time goes by, negative adjustments will slowly reverse, and even go back to zero at the maturity date. This means a writedown now could potentially be just that: an accounting writedown on an income-producing asset that reverses over time.
Let’s think about this another way. Imagine that one day you lend a friend $1,000 for one year at a 10% interest rate. A year later, your friend repays the $1,000 plus the 10% interest. You earned 10%, helped a friend, and lost absolutely nothing.
Had rates risen to 20% during that time, however, you would have temporarily been in the same position the banks are in now. Would you have felt like your $1,000 loan was worth less because you could have gotten 20%? Would you have temporarily marked down the loan only to reverse it when your friend paid it off?
This is a simple metaphor, but it’s essentially what is going on with the banks lately. The only difference is that instead of your friend, the banks are investing their liquid funds in very secure government notes.
If you’re still following, let’s try to think about this from a bank’s point of view:
We have a ton of extra cash hanging around right now because we are building a “fortress” balance sheet. We have no real pressure to loan out money at the current rates because we think rates will continue to rise as they have been doing lately.
Since we put our liquidity — and a lot of it — in investments that are making money but losing value, our incentive to hold these investments to maturity increases as interest rates rise, and the losses we would take upon selling grows.