While the larger Tier one and the medium sized Tier two banks saw their net profits grow by 21 percent year-on-year in 2022, the amount of unrealised losses on the securities portfolio they held on their books rose four times to Sh66 billion, primarily due to rising rates.
Specifically, Equity Group holdings reported unrealised losses of Sh29 billion on its securities portfolio, which was the highest in the market.
This is more than the Sh15 billion the group will be paying its shareholders in dividends.
As is the convention in fixed-income markets, when interest rates rise, bond prices fall. Banks then have to either re-adjust their holdings or seek funding to cover cash shortfalls, failure to, which they run a risk of falling into funding stress.
However, under accounting rules, banks don’t have to recognise losses on their holdings unless they sell them, so they are reported outside the income statement (and you’d have to be keen to spot them).
The rise in unrealised losses is also a function of banks opting to allocate liquidity to government debt over the past five years over lending to the real economy (citing supply-side constraints such as elevated credit risk in the economy).
As a result, the share of banks’ securities portfolio rose to a third of total assets in Q2 2022, from just 20 percent at the close of 2014.
Strictly speaking, 30 percent levels introduce an element of concentration risks on bank balance sheets.
And if anything, government debt is no longer ‘risk-free’ and banks should now be holding capital against the government portfolios.
Eventually, these revaluation losses come into play particularly when there’s funding stress in the market. For banks with a huge reliance on wholesale deposits as a funding source (particularly the tier two and some tier one banks), large withdrawal of deposits means they have to cover the gaps by selling part of their portfolios in the open market at much higher interest rates, which then triggers the realisation of these losses.
This is exactly what triggered the recent failure of Silicon Valley Bank (SVB) in the United States.
But banks can put forward two counter-arguments. First, they will argue they have enough capital to absorb any realised losses.
Indeed, the amount of unrealised losses at the close of 2022 was only the equivalent of nine percent of their core capital.
This counter-argument may not suffice because bank failures over the past 15 years have proven that while capital is used to guarantee the business, it often does not provide an effective first-line defence against such losses.
The second counter-argument is that unrealised losses evaporate with bonds over time when they are held to maturity and are redeemed, assuming there is no counterparty default.
Broadly, banks classify their holdings of government bonds into three buckets, namely (i) available for trading (which basically constitutes their daily trading book and is marked-to-market on a daily basis); (ii) available for sale (which is held for the purposes of benefiting from their financial position and not for the sole purpose of realising a short-term capital gain); and (iii) held-to maturity, which is purchased with the intention of holding until maturity.
The first two are marked-to-market on a regular basis and any loss or profit is recognised during the trading period.
However, over the course of the life of the two, both interest rates and liquidity go through peak-and-trough cycles.
While shareholders will be receiving their dividends, they need to ask tough questions about unrealised losses on their investee’s books and plans that have been put in place to unwind the losses.
If management is relying on luck to vaporise the losses, then they are doomed.