In 2023, the U.S. banking system experienced significant upheaval, marked by the collapse of Silicon Valley Bank (SVB) and emergency government interventions to stabilize other mid-sized banks. SVB failed after suffering severe losses on long-term securities: financial assets, such as bonds or mortgage-backed securities, that mature over an extended period (typically more than a year) and are sensitive to interest rate changes as interest rates surged. The problem for SVB was that it had invested a large portion of its deposits, most of them uninsured, in long-term securities. When interest rates spiked, those securities plummeted in value and the bank was forced to sell off bonds to cover losses, which triggered a run by panicky depositors who feared losing their money. Within two days the bank collapsed. To contain the crisis and prevent broader financial contagion, regulators took extraordinary measures, including guaranteeing all deposits at SVB and launching new liquidity programs for struggling banks.
These events exposed that the effects of interest rate hikes on bank solvency are poorly understood. Existing models and regulatory frameworks are built on assumptions that imply that the present value: the current worth of future cash flows, discounted to reflect the time value of money of banks’ earnings from lending and deposit-taking net of operating costs—their franchise value: the present value of a bank’s future profits from lending and deposit-taking net of operating costs —rises with interest rates. For example, one such assumption is that operating costs are insensitive to interest rate changes, while the spread between lending and deposit rates earned by banks rise with interest rates. In this case, the present value of future operating costs falls in response to higher interest rates, while the present value of future cash flows earned from spreads stays stable, leading to an overall increase in value. However, empirical evidence that the components of banks’ earnings conform to these assumptions is lacking. This paper fills this gap by analyzing financial reports from U.S. banks spanning 1984 to 2021 to analyze how banks generate revenue from loans and deposits, while accounting for operating costs. They find the following:
- Banks’ franchise value has positive duration: a measure of interest rate sensitivity indicating that an asset’s value declines when interest rates rise , meaning it declines when interest rates rise. This contradicts prior models that predict that the franchise value would rise with interest rates. The long-term securities held by many banks also have positive duration, which means these securities holdings exacerbate rather than hedge the interest rate risk of banks’ lending and deposit-taking business.
- Banks that do not raise their deposit rates significantly in response to rising interest rates tend to invest more in long-term securities. While this strategy helps insulate banks’ cash flows from exposure to interest rate fluctuations, it increases solvency risk because the value of those securities and the bank’s franchise value falls simultaneously when interest rates rise.
- Despite significant recent rate hike losses, most U.S. banks still retain sufficient franchise value to remain solvent, justifying forbearance: a temporary regulatory allowance that lets banks delay recognizing losses or meeting certain financial requirements to help them remain solvent during crises .
The authors highlight a trade-off between cash-flow hedging, which stabilizes earnings, and value hedging, which protects solvency. While holding longer-term securities can help smooth earnings, it also increases duration risk, making banks more vulnerable to interest rate fluctuations. The findings suggest that for regulators’ models to accurately reflect the solvency risk resulting from interest rate hikes, they must reflect the positive duration of bank franchise value.