Following a widely cited report on unrecognized bank losses due to interest rate rises, Amit Seru and his co-authors have taken a close look at how banks used hedging to offset the recent rise in interest rate risk. Not only do they find minimal use of the tool, but banks that were most vulnerable, like Silicon Valley Bank, actually decreased use of interest rate hedging as rates began to climb.
Jiang et al. (2023) argue that the Federal Reserve Bank’s decision to raise interest rates due to inflation had a significant impact on the value of U.S. banks’ assets, resulting in an unrealized loss of $2.2 trillion. This left banks that relied on uninsured deposits vulnerable to solvency runs. The authors contend that without regulatory intervention, nearly 200 banks were at high risk of experiencing such runs, as demonstrated by the failure of Silicon Valley Bank—the largest bank failure since the Great Recession.
Did some banks insure themselves against interest rate risk during the 2022 monetary policy tightening? My co-authors — Erica Jiang, Gregor Matvos and Tomasz Piskorski — and I recently conducted a study that reveals two findings that speak to this question. Firstly, we found that the use of hedging and interest rate derivatives did not adequately mitigate the interest rate exposure of U.S. banks or the $2.2 trillion loss in their assets’ value. Secondly, banks with high uninsured leverage, which had the most vulnerable funding, resorted to selling or reducing their hedges during the monetary tightening, reminiscent of gambling for resurrection.
We use two complementary data sources to shed light on the scale and importance of banks’ hedging activity. The first source is bank call report data (Form 031 and 041). Banks with asset value above the reporting threshold of $5 billion are required to report the notional value of non-trading purpose interest rate swaps in Schedule RC-L. In total, there are 1,288 banks with assets above the reporting threshold in 2021:Q4, comprising about 94% of all bank assets.
The second source is 10K and 10Q filings for all publicly traded banks (240 banks, including SVB) that account for 68% of all bank assets. Since banks can in principle use derivatives other than interest rate swaps to hedge interest rate risk, their voluntary disclosure in these filings allows us to construct their hedging activity more broadly.
Because hedging information is not reported in consistent formats across banks, such as being occasionally reported in footnotes, we hand collect and systematize the data. In total, 98 bank reported hedging related information in their 10K and 10Q filings and 62 publicly traded banks report their total asset duration in their 10K disclosures for 2021, which we use in our analysis as well.
Where Banks Stood at the End of 2021
Our analysis reveals that banks make limited use of hedging, indicating that even with derivatives, their assets remain substantially exposed to interest rate risk. At the end of 2021, prior to interest rate hikes, more than three-quarters of all banks with asset values above the reporting threshold did not report significant use of interest rate swaps. Usage of interest rate swaps is concentrated among larger banks, which hedge only a small portion of their assets.
While at least 75% of all bank assets used some swaps, they hedged only 4% of their total assets, or approximately a quarter of their securities. In total, interest rate swaps hedged only 6% of the aggregate assets in the U.S. banking system. As a point of reference, Jiang et al. (2023) argue that over 70% of bank assets were exposed to interest rate risk during this period, indicating that our findings are consistent with broader measures of hedging.
Similarly, we observe comparable outcomes using more expansive measures of hedging from the 240 publicly traded (larger) banks at the end of 2021. Over 60% of these banks do not report their hedges, while the very largest banks that do report their hedges only hedge around 9% of their assets and less than one-third of their securities. Overall, the largest banks rely on hedging to a greater extent than smaller banks, but their hedges leave the vast majority of interest rate risk unmitigated.
The notion that banks’ assets remain vulnerable to significant interest rate risk despite hedging has been confirmed by an analysis of 62 banks that disclose the duration of their total assets, including derivatives. On average, the duration is 4.6 (ignoring convexity), which means that a two percentage points rise in interest rates, which is exactly what happened in the last year, could result in implied losses amounting to over 9% of the asset value. In essence, the utilization of hedging and other interest rate derivatives was insufficient to counteract the majority of the $2.2 trillion loss in the value of U.S. banks’ assets.
Vulnerable Banks Hedged Less When Rates Rose
It would be reasonable to assume that banks facing higher risks would make greater use of hedging. However, our research shows little support for this assumption. In fact, banks that incurred greater marked-to-market losses on their assets as a result of interest rate increases tended to use hedging less. Although we find that banks who fund with more run-prone uninsured deposits are more likely to use interest rate swaps, the actual amounts hedged barely increase with funding fragility.
Lastly, our study reveals banks that rely on more vulnerable funding sources decreased their hedging activities during the monetary tightening period. It could be hypothesized that banks facing a higher risk of solvency runs would have a stronger motivation to protect their asset values and avoid failure, which might prompt them to increase their hedging activities. However, our findings indicate that banks with a higher proportion of uninsured deposits (uninsured leverage) chose to sell or decrease their hedges in 2022. As a result, these banks experienced greater losses when interest rates rose further due to their reduced hedging protection.
The case of the recently failed Silicon Valley Bank (SVB) provides a pertinent example. At the end of 2021, SVB hedged approximately 12% of their securities. However, by the end of 2022, this figure had fallen dramatically to just 0.4% of all securities, while the duration of their assets had risen by almost two years. As a result, every additional percentage point increase in the policy rate led to a two-percentage point larger decrease in asset values compared to 2021.
Reduction in hedges by the banks with more fragile funding is suggestive of gambling for resurrection. By selling profitable hedges, weak banks can boost their current accounting earnings, but they are also taking a significant risk. While bank shareholders may profit from this strategy on the upside, any losses are ultimately borne by the FDIC on the downside.
The current situation in the banking industry has raised concerns about the risk management and disclosure practices employed by US banks, with similar discussions taking place in the aftermath of the 2007 financial crisis. Our experience analyzing the data suggests that the current structure of banks’ risk management disclosures makes it very difficult to obtain a complete picture of banks’ risk exposures.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.