Rising Rates Are Like a Sugar High for Banks

Popular theory holds that rising rates are a net positive for banks. The idea is that if they can avoid raising their deposit rates in lockstep, they can wring out more income by earning a higher spread on deposits.

But as the failure of Silicon Valley Bank in March 2023 showed, that’s only part of the story. SVB got in trouble because of what was happening on the other side of its balance sheet: The bank held a lot of long-term Treasurys, which fell in value as rates rose. Unable to ride out the rate hit by holding the bonds to maturity, the bank had to sell them at losses to meet withdrawal demand from customers who had caught wind of the declining value of the bank’s assets. Cue a bank-run spiral, as worried customers—many with balances exceeding FDIC insurance coverage—forced the bank to keep liquidating its depressed bond portfolio.

To estimate the total effect of rising rates on banks’ equity value, it’s important to account for what happens on both the deposit and asset sides of the ledger, and for how banks’ future profits are discounted, points out research by Stanford’s Peter DeMarzo and Arvind Krishnamurthy and Chicago Booth’s Stefan Nagel. Doing just this, they find that franchise value typically falls when rates rise.

Despite the popular theory, a model from the researchers predicts that franchise value on the deposit side acts like a floating rate bond: The spread moves up and down along with rates but doesn’t increase long-term value because the discount rate at which banks’ stream of future profits is valued moves up and down as well. At the same time, a spread earned on assets reacts more like the yield on a fixed-rate bond. When rates rise, the bank’s investment portfolio earns below-market rates. Assuming operating costs are held constant, the net result is a decline in franchise value, which can exacerbate losses in a bank’s rate-sensitive investments.

The researchers compiled quarterly data on bank operations from the first quarter of 1984 to the first quarter of 2021. The estimate of franchise value was culled from more than 3,800 banks in early 2021. The model estimates that banks’ ratio of equity to tangible assets declined by about 5.8 percentage points for the median bank, of which 2.2 percentage points were due to a decline in franchise value and 3.6 percentage points due to a drop in the value of its securities. The losses were nearly double for banks that were most reliant on long-term bonds. This helps explain what happened at SVB, which had a large investment in long-term Treasurys.

DeMarzo, Krishnamurthy, and Nagel stress that while their aggregate data show a decline in franchise value amid rising rates, this does not signal a widespread solvency crisis, as banks in the aggregate have positive franchise values. Long-term profitability may be weaker due to rising rates; but overall, banks are still profitable.

Yet the researchers note that while SVB was an outlier, many banks faced losses, just to a lesser degree. Their data indicate that midsize banks in general tend to have a bigger stake in long-term securities. This finding suggests banks and regulators may benefit from rethinking whether current risk management sufficiently addresses the potential impact of rising interest rates—especially because regulatory guidelines could play a part in why rising rates knock down value.

Regulators encourage banks to treat some of their deposit liabilities as if they were long-term liabilities—an acknowledgment that not all deposits will remain sticky forever and banks should plan for those deposits to be withdrawn. This can motivate banks to park more of their assets in long-term debt, as doing so seemingly hedges the interest rate risk of the deposit side of the franchise.

But this treatment is inconsistent with the perpetual floating-rate nature of the spreads that banks earn on deposits, the researchers point out—noting that long-duration assets increase the interest rate risk exposure of banks’ equity rather than hedge it. “Regulators’ valuation approach may appear prudent from a liquidity/bank-run risk perspective, but actually gets it exactly wrong from an interest rate risk perspective,” explains Nagel.

And this can be particularly important in an increasingly technological banking environment, where heightened interest rate risk can quickly turn into a liquidity crisis. As the failure of SVB illustrates, digital-forward customers wasted no time bailing when word got out that the bank had a large investment in long-term bonds, which lost value as rates rose. And that may well be a typical reaction of depositors now that digital banking has made it easier for customers to move money. (For more, read “Why Your Banking App Might Spell Trouble for Your Bank.”)