KC Fed, Report: The Implications of Unrealized Losses for Banks

“Rising interest rates have reduced asset prices substantially in the last year, including prices of securities held on bank balance sheets. Un­realized losses reduce a bank’s total value and may negatively influence capital and other financial ratios, with broader implications for banks and the economy.”

“We discuss four ways that declining securities valuations may in­fluence bank behavior. First, higher unrealized losses threaten the sol­vency of the bank, increasing firm risk and driving up equity funding costs. Second, the inability or reluctance of banks to sell securities in loss positions can increase debt usage, further raising funding costs. Debt investors can also drive up funding costs as they demand higher spreads to compensate for increased insolvency risk. Third, as funding costs increase, banks may raise the cost of lending or tighten lending standards because they are reluctant to sell securities to generate loan­able funds. And fourth, banks with large unrealized losses may be re­luctant to market themselves for acquisition if they believe underwater securities have temporarily depressed offer prices. Similarly, bank buy­ers may be reluctant to engage in acquisitions if they are wary of the risks underwater securities pose to acquisition targets.”