The Federal Reserve Bank of San Fransico has estimated that all the pandemic-era excess savings has left the system (see the charts below).

It would be nice to think that we can simply return to the pre-pandemic management of our funding and liquidity as though nothing happened of lasting effect.

That, however, is not the case. Infact, most “NIM-challenged” banks, tired of carrying so much cash on their balance sheets, and eventually capitulated and began en masse to buy securities to try and eke out some sort of yield on these deposit inflows.

Unfortunately, at the same time many bankers seemed to forget the basic tenants of interest rate risk management and doubled down on a “low-forever” outlook for rates and bought mortgage-backed securities to squeeze out another 30bps of yield over short-duration treasuries.

As a result, when rates rose, and the deposits started leaving the system, many banks suffered massive declines in securities values that remain a significant drain on earnings. In many cases, the declines were so severe that, in order to not suffer the hit to regulatory capital that would result should they crystalize these losses, banks had to borrow funds to replace the outflow of deposits.

In fact, over half of all banks (51%) are suffering negative carry from the difference between the yield on those mortgage-backed securities and the rate they are paying on borrowed money to fund them.

Chart 1 shows the extent to which this negative carry is dragging on ROTCE for each of the nearly 2,000 banks in this situation.

Chart 1

At least one implication of this fact set, beyond the drag on earnings, is that regulatory policy regarding the reversal of unrealized losses for regulatory purposes needs to change.

It is inconceivable that so many banks would be in this condition today had they taken small doses of declining regulatory capital ratios after the first rate rise. They would have sold securities instantly while they had the liquidity to do so without being tempted to “ride it out” to such long-lasting, negative effect.

Another implication is that, once again, the Federal Home Loan Bank System is proving itself to be a wealth transfer mechanism to more sophisticated banks at the cost of increasing demonstrably the risk to the FDIC, which as a result of the FHLB’s hold on bank assets, will inevitably suffer significantly higher loss given failure for the banks whose deposits it insures.