As the second quarter of 2024 closes, a troubling picture of the U.S. banking sector has emerged. Unrealised losses on investment securities held by American banks have swelled to a staggering $512.9 billion. To put that into perspective, these losses are now seven times larger than at the peak of the 2008 financial crisis, a comparison that underscores the strain financial institutions are under in the current economic climate.
The growth of these losses has been relentless. Q2 2024 marks the 11th consecutive quarter where losses of this nature have persisted, driven largely by the weight of interest rate pressures. Banks, which once profited handsomely from a lower interest rate environment, are now grappling with the aftermath of prolonged rate hikes that have dented the value of their held-to-maturity securities. This issue isn’t confined to a handful of smaller institutions either; even the country’s largest financial players are feeling the pressure.
Take Bank of America, for instance. As the second-largest lender in the United States, it accounts for a whopping $110.8 billion of the total unrealised losses in held-to-maturity securities. That’s nearly 20% of the entire figure across all U.S. banks. While Bank of America’s sheer size may make such numbers easier to absorb, the situation highlights how even the biggest names in banking are not immune to the risks currently gripping the sector.
For context, these unrealised losses represent the gap between what banks paid for securities—often government or corporate bonds—and their current market value. As interest rates have risen, the value of these bonds has fallen, leaving banks in a bind. If they were forced to sell these securities today, they would have to accept significant losses, and though the term “unrealised” suggests these losses haven’t been officially recorded yet, the ongoing rate environment suggests they may stick around for some time.
Adding to the complexity, the Federal Deposit Insurance Corporation (FDIC) has revealed a concerning uptick in the number of banks listed on their Problem Bank List. In Q1 2024, this list grew to include 66 banks, which represents about 1.5% of all U.S. banks. While the number of problem banks remains low compared to the years following the financial crisis of 2008, the trend is clearly headed in the wrong direction. The banks on this list are deemed to be at risk of failing, so the increase is another worrying sign that the pressures building in the financial system could soon claim some casualties.
The reality is that banks have been trying to manage these challenges since interest rates began to climb in earnest. While many have the capital reserves to weather the storm, others, particularly smaller regional banks, face a more uncertain future. These smaller institutions are not only dealing with unrealised losses on their securities portfolios, but many are also heavily exposed to another area of concern: commercial real estate.
As of 2024, small banks hold an estimated 70% of outstanding commercial real estate debt, a sector that is increasingly seen as vulnerable to default. Many commercial real estate loans, issued when interest rates were lower, are now becoming burdensome as rates rise. Office spaces, shopping centres, and other commercial properties have seen their values decline, driven by lower occupancy rates and shifting economic dynamics post-pandemic. With many tenants unable or unwilling to pay higher rents, the risk of default on these loans has grown substantially. For the banks holding this debt, the stakes are high. If defaults start to mount, it could trigger a cascade of financial stress that might extend beyond these smaller lenders.
At the same time, recent rate cuts haven’t provided the relief many hoped they would. While the Federal Reserve has started to bring interest rates down slightly, signalling a potential easing in monetary policy, the banking sector is far from out of the woods. Experts have cautioned that just because rates have begun to decline, it doesn’t mean that the road ahead will be smooth. Many banks are still grappling with the aftermath of rapid rate hikes over the past two years, and the financial landscape remains precarious.
One of the key challenges is that, even with rate cuts, the long-term impact of higher rates will be felt for some time. Banks are locked into many of their investments and loan agreements, which were made in a vastly different interest rate environment. As such, the downward pressure on the value of their securities portfolios is unlikely to reverse quickly. Moreover, the commercial real estate sector remains under immense strain, with defaults a real possibility in the near future.
So, what does this all mean for the average person? For most, the direct impact of these unrealised losses may not be immediately felt. However, if the strain on banks continues to grow, it could start to affect broader economic conditions. Tighter lending standards, for example, may become more prevalent as banks seek to protect themselves from further risk. This could make it harder for individuals and businesses to get loans, potentially slowing down economic growth at a time when the U.S. economy is already facing significant challenges.
Moreover, if more banks start to appear on the FDIC’s Problem Bank List, or if defaults in the commercial real estate sector spike, it could lead to a broader loss of confidence in the financial system. While the U.S. banking sector is much more robust today than it was in 2008—thanks in part to post-crisis regulations designed to shore up capital reserves and limit risky behaviour—there are still vulnerabilities that could be exposed if conditions worsen.
There’s also the question of how regulators will respond to these growing challenges. The Federal Reserve and the FDIC have been monitoring the situation closely, but with inflation still a concern and economic growth slowing, there are limits to what monetary policy can achieve. Rate cuts may provide some relief, but they can’t undo the losses that banks have already accumulated. Meanwhile, stricter regulation of the banking sector could be on the horizon, particularly if more banks show signs of financial distress.
For now, the focus will likely remain on managing the fallout from higher interest rates and ensuring that banks have the capital to absorb any further losses. However, the underlying challenges—such as the risk of defaults in commercial real estate and the potential for further pressure on smaller regional banks—will need to be addressed to prevent a broader financial crisis.
As 2024 continues, the financial system remains under close scrutiny. The staggering level of unrealised losses on investment securities is a reminder that, while the worst of the financial crisis may be behind us, there are still significant risks that could impact the stability of the banking sector. Whether it’s through further rate adjustments, regulatory changes, or a shift in economic conditions, it’s clear that banks will need to remain vigilant as they navigate this uncertain landscape.
The next few quarters will be critical in determining how the banking sector fares. For now, though, the burden of $512.9 billion in unrealised losses looms large, and the path forward is far from clear.
