When Market Conditions Turn Volatile, Why Don’t Banks Use Bond Portfolios as Shock Absorbers?

As the U.S. economy bounced back from the COVID shock, the Federal Reserve increased its target for the Federal Funds interest rate from nearly zero percent to 5.25–5.5 percent by July 2023. This raised other interest rates in the economy.

These higher interest rates put pressure on banks' bond portfolios. The assets in these portfolios — mostly Treasury bonds and mortgage-backed securities — fell below par value and into what Wall Street calls “underwater” territory. At the same time, certain bonds became increasingly risky, particularly bonds backed by residential mortgages. As rates moved higher, fewer homeowners refinanced their mortgages, extending the maturity on these bonds and heightening their sensitivity to interest rate movements. Meanwhile, higher rates prompted customers to withdraw money from their deposit accounts, straining bank liquidity and raising the risk profile of their balance sheets. Together, these trends created a strong headwind for banks. It had been a long time since risk was so concentrated and elevated.

During this period of rapidly changing market conditions, one might have reasonably expected banks to use their bond portfolios to actively manage risk. But as three economists show in a recent working paper, “Underwater: Strategic Trading and Risk Management in Bank Securities Portfolios,” banks made only limited adjustments: They bought shorter-term securities, and they reclassified some of their existing bond holdings to make risk less salient. Surprisingly, they rarely sold risky bonds, and they largely avoided pursuing hedging strategies.

Why didn’t banks use their bond positions more actively as risk-management tools? To lessen duration risk, for instance, longer-term bonds could have been sold and replaced with shorter-term issues. (Shorter-dated bonds tend to be less sensitive to swings in interest rates, so they reduce volatility when markets get choppy.) Greater use of financial hedges (for example, interest rate swaps) could also have mitigated interest rate risk. Such hedges help offset losses from declining bond prices by essentially functioning as an insurance contract in which a party agrees to cover another party’s losses on a particular bond should that bond experience a decline in value. But the working paper shows no evidence of an increase in hedging sufficient to offset rising interest rate risk during the 2022–2023 period of rising rates. 

Another tool to minimize the effects of bond price volatility is to classify certain bonds as held-to-maturity (HTM) securities. Doing so allows a bank to avoid booking unrealized losses that might accrue to these securities — so long as they are not sold before their maturity date. Interestingly, banks did pursue HTM classifications to a fair extent. But because of how these securities function (as described below), the classification of bonds as HTM likely constrained banks’ ability to trade bonds in significant quantities. 

By investigating how banks manage their securities portfolios, Andreas Fuster, Teodora Paligorova, and James Vickery shed light on the frictions banks encounter when considering whether to adjust their bond holdings.¹ First, they assessed bank assets down to the individual security, identifying bond traits such as par value, maturity date, coupon payment, valuation, and type of issuer.² Then, using data collected by the Federal Reserve as well as public data from regulatory filings (including quarterly and annual reports, which typically include a discussion of risks posed by these types of assets), they pinpointed which banks held each type of bond.³

Among other findings, the authors show how, during the 2022–2023 rate-tightening cycle, banks were incentivized not to sell underwater bonds even when their need for liquidity and interest-rate risk management intensified. This is because if a bank sells its underwater bonds, the losses on those bonds will be immediately reflected in the bank's earnings and, for most banks, its regulatory capital. These implications had significant consequences for bank behavior. The authors estimate the odds of selling to be 8.3 times higher for above-par bonds than for underwater bonds.

The use of hedges was similarly hampered by regulatory and accounting requirements. Banks often rely on qualified hedges, which are subject to stringent rules. For example, banks must thoroughly document how each hedge counteracts the specific risk it is being employed against.⁴ What's more, banks are less likely to hedge bonds that can be retired early, such as mortgage-backed securities, which for many banks comprise more than 50 percent of their securities portfolios. This is important because mortgage-backed securities can dramatically decline in value when interest rates rise. As the authors show, during the 2022–2023 rate-tightening cycle some banks faced larger losses than others, and banks with a large exposure to mortgage-backed securities were especially vulnerable. In combination with other factors, some banks were unable to recover from these losses, as was the case with Silicon Valley Bank, which ultimately closed its doors.

Bonds are a major part of banks’ investment portfolios. Like other types of securities, bonds have a dual nature: On one hand, they are vulnerable to risks, and on the other, they are highly liquid and can play a role in managing risk. In theory, bonds can be sold when they fall out of favor and then replaced with bonds that are better suited to prevailing market conditions. If it were more straightforward for banks to sell their underwater bonds, perhaps they would be better equipped to navigate market episodes like those that transpired in 2022–2023, when rising rates dampened bond portfolios. As the authors point out, updated regulatory and accounting conventions could help address this issue. Given that banks are crucial to ensuring a viable financial system, such improvements may also benefit the economy at large.