The recent turmoil that we have seen in the US and Uk banking sectors can be characterized as out-of-left field type events that came as a surprise as a result of the speed of the risk and the very fast passage to failure of the banks involved. The lessons we can learn from the recent episode is that a combination of banking risks such as the lack of diversification, aggressive growth trajectory, maturity mismatches and high sensitivity to liquidity risks, and the capital treatment of unrealized losses in Available –for sale and held-To-maturity assets - left unsupervised can lead to a bad outcome.
According to FDIC unrealized losses in the US banking sector on Available-for- Sale and Held-to-Maturity totaled $620 billion in the last quarter of 2022 with a significant amount of these assets held in long-maturity profiles. Hence the combination of long-maturity assets, in a rising interest rate environment, and unrealized losses, coupled with a rising likelihood of potential for geopolitical shock, in addition to the financial stability risks arising in the US nonbank institutions such as money market funds and hedge funds, who engage in liquidity and maturity transformation by profiting by issuing short-term obligation, e.g commercial paper and invest proceeds in riskier and long-term assets highlights the risk that these unrealized losses can become actual should these banks need to sell assets to meet liquidity needs. This is a latent vulnerability and can be amplified by a range of low-probability, high-consequence events including the emerging Sino-Russia partnership, NATO expansion, Saudi-Iran diplomatic deal, U.S. tech tariffs and industrial policy, a wave of global strikes and mass protests, and the mega-election year to come in 2024.
