Board of Governors of the Federal Reserve System

August 30, 2024

The interaction of bank leverage, interest rate risk, and runnable funding

Shawn Kimble and Matthew P. Seay¹

Summary

Silicon Valley Bank (SVB), Signature Bank, First Republic Bank (FRC) had too little useable liquidity relative to their runnable funding and too little capital given the magnitude of their interest rate risk. The mismanagement of these vulnerabilities ultimately contributed to a loss of confidence in their business models. While SVB, Signature, and FRC were outliers, we analyze the build-up of fragilities in the banking system that preceded their failures.

In this Note, we introduce a measure called lower friction liquidity (LFL). LFL is the ratio of liquid, useable assets (cash and useable available-for-sale (AFS) securities) to runnable liabilities (uninsured deposits and short-term wholesale funding (STWF)). Useable AFS is defined as the maximum amount of AFS a firm can liquidate to meet outflows without breaching its total common equity tier 1 (CET1) ratio requirement. We also construct market-adjusted common equity tier 1 (MACET1) ratios to account for unrealized fair value losses on all bank securities and loans in bank capital ratios. We use these two measures to analyze the interaction of banks' liquidity and solvency risks.

While there is no perfect measure of bank capital or liquidity, LFL captures banks' capacity to meet outflows using assets that are easily convertible to cash while maintaining regulatory capital requirements. It assumes severe financial conditions, similar to those that prevailed during the spring of 2023, in which vulnerable banks cannot rely on funding markets to shore up their cash positions and are unable to raise equity.

In this Note, we decompose the subcomponents of LFL ratios and show that in the year leading up to the failure of SVB, banks with lower LFL ratios shed more cash than their peers and retained fewer AFS securities, despite a comparable build in uninsured deposits. Following the failure of SVB, banks with low LFL ratios had worse stock price returns than their peers – suggesting that markets overlooked this interaction of vulnerabilities until the firm failed. In addition, firms with low LFL ratios displayed less ability to retain their uninsured depositors following SVB's collapse, despite significantly boosting their useable, liquid asset positions.

Our analysis highlights that firms in the bottom quartile of the LFL ratio distribution could cover just one-third of their runnable funding by selling their most useable, liquid assets. In general, large fair value losses can impair the usability of high duration liquid assets should funding stress emerge.² For the subset of otherwise solvent institutions with viable business models but too little useable liquidity, discount window readiness or access to contingent liquidity facilities could provide balance sheet flexibility and delay or mitigate potential bank failures and contagion.³ For the subset of firms that operate with sufficient liquidity but elevated interest rate risk, more capital could also help stave-off a run equilibrium.⁴

Limited ability to sell assets without depleting capital

Fragilities began to build in the banking system several years prior to SVB's collapse. From 2020 to 2022, banks invested heavily in longer-maturity securities and loans (figure 1, left). At the time, yields on these assets were low relative to current levels, but offered a premium relative to short-term investments. Higher reliance on longer-maturity assets left some banks' capital positions increasingly vulnerable to higher long-term yields. That vulnerability manifested during 2022, when inflation unexpectedly rose, which corresponded with a large rise in long-term yields, and led to substantial reductions in the fair value of fixed-rated bank loans and securities.

To illustrate the impact of these unrealized losses on banks' regulatory capital, we construct MACET1 ratios. The MACET1 ratio is a non-regulatory risk-based measure of capital that accounts for fair value losses of all securities and loans.⁵ MACET1 ratios illustrate that bank capital would be significantly depleted in an extreme scenario where fair value losses are realized (figure 1, right).⁶

Figure 1. Longer maturity assets and lower capital

Imbalance of runnable funding and useable, liquid assets

Uninsured deposits increased substantially as the federal response to the pandemic made its way into the banking system during 2020. At an aggregate level, this growth of runnable funding was mostly matched with higher cash positions (including reserves) and larger holdings of AFS through 2021 (figure 2). As the pandemic waned and the Fed tightened monetary policy, the quantity of reserves in the banking system shrank. In addition, some banks reduced their AFS portfolios, despite maintaining a high reliance on uninsured deposits. This imbalance of runnable funding relative to useable, liquid assets peaked during the second half of 2022 and left a subset of banks less equipped to meet deposit outflows without either increasing reliance on repo market depth, turning to other funding sources such as Federal Home Loan Banks (FHLBs), or using the discount window (DW).⁷

Figure 2. Components of useable liquid assets and runnable liabilities

Lower friction liquidity: the interaction of runnable funding, interest rate risk, and leverage

While many firms had sufficient asset-liquidity to meet the runnability of their liability base, some banks failed to correct this imbalance and adequately manage the interaction of their risks. LFL ratios provide one way to analyze bank resiliency based on the interaction of a bank's liquidity, interest rate risk, and capital positions. Banks with lower LFL ratios have less liquidity immediately available to manage higher cash demand from their depositors and short-term lenders without increasing borrowings and have less flexibility to shrink their balance sheets without raising more capital.⁸

More formally, LFL is the ratio of banks' useable, liquid assets to their runnable liabilities. We define useable, liquid assets as cash (including reserves) and useable AFS, where useable AFS is the maximum amount of AFS securities a firm can liquidate to meet outflows without breaching its total CET1 capital requirement.⁹ We assume that banks sell each dollar of securities at a loss rate equivalent to the average fair value decline of the AFS portfolio.^{10 , 11}

Runnable liabilities – the denominator of LFL ratios – are the sum of uninsured deposits and short-term wholesale funding (STWF), where STWF is the sum of federal funds borrowing, repurchase agreements, foreign deposits, trading liabilities, other borrowings with a remaining maturity < 1-year, commercial paper, and long-term debt scheduled to mature < 1-year. The measure assumes a system-wide run. Under this extreme assumption, banks have no ability to retain their uninsured deposits.

The left panel of figure 3 shows that banks' ability to meet runnable funding outflows – as measured by LFL ratios – rose gradually during 2018 to 2019. During the early stages of the pandemic, LFL ratios were bolstered by significant holdings of AFS securities and reserves. LFL ratios declined materially during 2022, as uninsured deposits remained fairly sticky while cash and reserve positions declined as the Fed tightened, and securities portfolios shifted toward held-to-maturity. This imbalance is demonstrated by the leftward shift in the distribution of firms' LFL ratios, as shown in the right panel of figure 3.

Figure 3. Distribution of LFL Ratios

How did runnable funding and liquidity evolve before and after the failure of SVB?

We next analyze how each of the LFL components (cash, useable AFS, uninsured deposits, and STWF) contributed to changes in banks' LFL ratios. We group banks into two categories based on the level of their LFL ratios as of 2022:Q4. Banks with LFL ratios less than 0.33 – roughly the bottom quartile of the distribution at that time – are grouped in the low LFL group, and all other banks are grouped in the high LFL group. We drop failed banks and exclude GSIBs.¹² We then create virtual, aggregate banks to represent the high and low LFL bank groups. We sum the data at the LFL component level each quarter across the individual banks in the group, and then create a single quarterly LFL measure from those aggregated data. This approach allows us to calculate percentage-point contributions to the quarterly change in each bank group's aggregate LFL ratio from each of our four LFL components and contrast how their positions evolved. On a quarterly basis, the four contribution amounts sum to the total change in our LFL measure. Figure 4 plots the contribution of each of our four components for each quarter. Data for the low LFL bank group are shown in the left panel, and those for the high LFL bank group are shown in the right panel.

Figure 4. LFL Decomposition for Low and High LFL Banks

The figures show the large influx of uninsured deposits across low and high LFL bank groups during 2020 and early 2021. During this time, both high and low LFL banks largely matched inflows of uninsured deposits with cash and AFS securities. Beginning in late 2021 and through 2022, low LFL banks shed significantly more cash and AFS securities despite maintaining high levels of uninsured deposits, which led to a material reduction in their ability to meet outflows. In contrast, firms with healthier LFL ratios maintained more of their useable liquidity through 2022. After SVB's failure, low LFL banks shored up significantly more liquidity by increasing their cash positions and moving toward AFS securities.¹³

When did markets price the interaction of interest rate risk and runnable funding?

While the largest banks are subject to more stringent regulatory requirements, such as the GSIB surcharge or the liquidity coverage ratio, any firm that severely mismanages its interest rate risk or funding positions, or their interaction, may face market discipline or heightened attention from depositors.

Figure 5 plots the simple average of cumulative stock price returns for low LFL banks (LFL ratio < .33) and all other firms (LFL ratios > .33). The chart suggests markets priced the interaction of vulnerabilities captured by low LFL ratios after the failure of SVB.¹⁴ Furthermore, the similar cumulative returns across both bank groups before the failure of SVB suggest evidence of parallel trends.

Figure 5. Cumulative returns by LFL group

We use cross-sectional analysis to explore this more formally. We assume market participants are informed by the latest available balance sheet information at the time of SVB's failure and use 2022:Q4 balance sheets to identify banks with similar vulnerabilities.¹⁵ Table 1 shows cumulative returns from March 8th to May 31st regressed on several vulnerability measures. The main variable of interest that separates the treatment and control in our specifications is a dummy variable which takes the value of 1 if a firm has a LFL ratio below 0.33 (within the bottom quartile of the distribution). Column (1) shows that banks with ex-ante vulnerability, with low LFL ratios as of 2022:Q4, underperformed their peers after the failure of SVB. In Column (2) we add two additional controls related to interest rate risk and runnable funding. We add a dummy variable set equal to 1 for firms with MACET1 ratios less than their total CET1 requirement. This control is designed to capture firms that may need to raise equity to cover interest rate risk stemming from securities and loans (FV losses) in the event of a severe bank run. We add a separate control for runnable funding using a dummy variable equal to 1 for firms with above-average reliance on uninsured deposits. Our findings suggest that low LFL ratios are associated with worse stock price performance after SVB's failure, above what can be gleaned from interest rate risk and runnable funding individually.

Column (3) includes a dummy variable for firms with MACET1 ratios less than 4.5 percent. Banks with CET1 ratios less than 4.5 percent are considered undercapitalized by PCA standards. While MACET1 is not a regulatory capital measure, we apply the 4.5 percent as a solvency threshold to identify potentially vulnerable banks with too little capital relative to their interest rate risk and its interaction with above-average reliance on uninsured deposits. Our results are robust to these controls. Stock prices of banks with low LFL ratios underperformed their peers by 6.7 percentage points on average after the failure of SVB, as shown in Column (3) of table 1. This suggests market participants may have weighed banks' ability to meet deposit outflows in the short-term, and the interaction of solvency and runnable funding, similarly.

Table 1: Cumulative returns by LFL group

Did banks with larger imbalances of liquid assets to runnable funding have bigger uninsured deposit outflows?

Next, using similar cross-sectional analysis, we test whether banks with LFL ratios < 0.33 experienced larger uninsured deposit outflows relative to their peers following the SVB shock.¹⁶

We find that banks with low LFL ratios had roughly 8.2 percentage points less average quarterly uninsured deposit growth than their peers after the failure of SVB (Table 2, Column 1). Further, we show in Columns (2) and (3) that our uninsured deposit growth estimate is still economically and statistically significant after controlling for above-average reliance on uninsured deposits and MACET1 ratios less than 4.5 percent. These findings are consistent with the hypothesis that banks with an unmatched reliance on uninsured deposits (captured via lower LFL ratios, all else held equal), are likely to have greater difficulty in maintaining or attracting a stable deposit base.

Table 2: Uninsured deposit growth by LFL group

Conclusion

In this note we introduce a new measure called lower friction liquidity (LFL), which is the ratio of a banks' most useable, liquid assets to their most runnable liabilities. LFL ratios provide a way to highlight banks that have less ability to meet outflows of runnable funding based on their liquidity positions, interest rate risk, and capital positions. We provide some evidence that markets overlooked the interaction of these vulnerabilities until SVB failed. We also share some preliminary evidence that suggests banks with low LFL ratios had less ability to retain their uninsured deposits post-SVB, relative to their peers.

It is unlikely that the next set of bank failures will look like the last. However, our work suggests that otherwise solvent institutions with viable business models could better position their balance sheet to meet larger and faster outflows without significantly depleting their capital. Examples of such strategies include discount window readiness and access to other liquidity facilities. For firms with elevated interest rate risk but sufficient liquidity, more capital could also help prevent a run equilibrium.

References

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