Mind the GAAP: Assessing bank health in the current environment

By Alison Touhey
ABA Data Bank

Today, a number of political and economic anomalies are driving economic uncertainty, including the war in Ukraine, supply chain disruptions, the ongoing pandemic and inflation rates at generational highs. Individually, these events and circumstances would be notable, but together they are truly unprecedented.

Through all of this, the banking industry remains a source of strength for the economy, safekeeping savings, supporting consumers and providing capital to the businesses that drive economic growth. Banks entered the pandemic with high levels of capital and liquidity. As the pandemic unfolded, these strong balance sheets meant that banks were well-positioned to support their communities through the economic stress driven by emergency lockdowns. Savers and investors turned to banks as a place to weather the storm, and the federal government looked to banks to be the conduit for relief programs intended to ease the brunt of the pandemic’s economic effects.

As a result, deposits flooded the banking system. All told, the industry saw an unprecedented inflow of more than $5 trillion in deposits added to bank balance sheets in 2020 and 2021. But as deposits moved in, loan demand slowed so banks of all sizes invested the influx of deposits in high quality bonds, such as U.S. Treasury securities, GSE securities and municipal bonds. Accordingly, over that same time period, bank investment portfolios grew from nearly $4 trillion at the end of 2019 to more than $6.2 trillion in 2021.

Figure 1: Community Bank Holdings of Treasury Securities are up Almost 400 Percent from 2019. (Click image to enlarge.)

Investing pandemic-driven deposits in essentially risk-free assets means that banks’ exposure to credit risk did not increase as their balance sheets have grown. Today, banks remain liquid and well capitalized, and asset quality remains strong. The industry charge-off rate in the second quarter of 2022 was 0.23%—near historic lows—and total loan loss reserves remained above pre-pandemic levels.

Over the past year, as the global economy has emerged from the pandemic, inflation has picked up, leading the Federal Reserve to move away from its very accommodative monetary policy stance. Since the beginning of the year, the Federal Reserve has raised rates six times, from a target range of 0-25 basis points to now a target range of 375-400 basis points, resulting in a more than 375-basis-point rate increase in the target federal funds rate as of Nov. 4, 2022.

Figure 2: Fed Response to Inflation has Led to an Abrupt Rise in Benchmark Rates. (Click image to enlarge.)

The federal funds rate is the rate at which banks lend reserves to each other and is a key monetary policy tool. The interest rate on the 10-year Treasury is a benchmark rate for mortgages, and other borrowing such as corporate debt. As rates rise, the market value of a bond decreases. The Federal Reserve’s rapid rate increases after years of historically low rates means that market participants are adjusting to a new environment, and as such, valuations of even the safest securities are affected. This is particularly true for community banks, defined here as banks under $10 billion in assets, which currently hold a high level of Treasury securities.

The combination of historically large bond portfolios resulting from pandemic deposits and the Federal Reserve’s aggressive anti-inflation efforts means that some otherwise healthy banks are seeing temporary paper losses on their securities portfolios. The fluctuations in market value of bank securities portfolios flow through to some measures of capital. As a general matter, when assessing a bank’s performance and condition, it is important to do so holistically, using a variety of performance and condition metrics in addition to qualitative factors. It is equally important to understand key differences in the way market and economic events are accounted for under different capital regimes.

Under generally accepted accounting principles, banks must classify securities as “held to maturity,” or HTM; “available for sale,” or AFS; or for trading depending on the purpose of the security purchase. As the name suggests, held to maturity assumes the security will be held until it matures, while AFS implies that a bank may sell the security before it reaches maturity. Because the bank may elect to sell an AFS security prior to maturity, they are marked-to-market on the balance sheet. Since community banks don’t typically hold securities for trading, and GAAP accounting for HTM securities can be cumbersome, smaller banks typically hold their securities portfolios as available for sale.

This means that until a security is sold or impaired, valuation changes run through equity via the accumulated other comprehensive income/loss account. Under tangible capital calculations, unrealized gains and losses are recorded as though the bank intends to immediately sell (or impair) all of its securities. This can make bank capital levels very volatile, due to market swings, while providing limited useful information about a bank’s condition. In recognition of this volatility, the regulatory capital framework defined by the Federal Reserve, FDIC and OCC gave all but the largest banks the option to elect to add or subtract the unrealized gains or losses back to regulatory capital.

Figure 3: Aggregate Bank Capital Ratios, Q2 2022. (Click image to enlarge.)

Bank capital regulations were updated almost 10 years ago to ensure that bank capital is robust, reflects modern banking and markets, and that, by extension, banks are able to withstand stress. By any measure, the banking industry remains well capitalized. However, since changes in bond valuation flow through to tangible capital calculations, for many banks, regulatory capital is a more accurate indicator of bank condition in a rising rate environment.

In addition, banks are very liquid based on the levels of deposits in the system. However, it is difficult to assess a bank’s current liquidity position or access to sources of liquidity in the event of stress using call report data. One rough proxy for community bank liquidity is the loan-to-deposit ratio. If the LTD ratio is high (close to or over 100 percent) it could signal strong loan demand and that a bank may need to raise additional funding to continue lending, all else equal. A lower ratio typically indicates that banks have lower loan demand or excess liquidity, all else equal.

Figure 4: Bank LTD Ratios. (Click image to enlarge.)

Banks analyze and manage their liquidity, interest rate and other risks through a variety of methods and are regularly examined to ensure their risk management frameworks are sufficient and robust. Generally, banks are healthy and resilient. As banks adapt to the new rate environment, regulatory capital, together with other risk metrics, is a better assessment than tangible-based capital measures when assessing bank condition. Relying solely on tangible capital, or other GAAP-based metrics, could give an erroneous impression of a bank’s condition.

Alison Touhey is VP for bank funding policy at ABA. She previously worked at the FDIC as a senior financial economist and a senior capital markets specialist. Tyler Mondres, senior director for research at ABA, contributed to this post.