SUNANDO ROY – On Banking, Finance and Society

( Abstract: U.S. banks face $500 billion in unrealized securities losses due to rising interest rates, highlighting the need for robust IRRBB management. The BCBS IRRBB framework guides banks in mitigating risks through EVE and NII metrics, with unique challenges for emerging markets.)

Recent insights from the Office of Financial Research (OFR) highlight a critical issue for banks: unrealized securities losses. As of Q4 2024, U.S. banks held approximately $500 billion in unrealized losses on their securities portfolios, driven largely by rising interest rates. These losses, while not immediately impacting earnings, pose a latent threat to banks’ capital and financial stability. This situation underscores the importance of robust regulatory frameworks like the Basel Committee on Banking Supervision’s (BCBS) Interest Rate Risk in the Banking Book (IRRBB) guidelines, which aim to manage the risks arising from interest rate fluctuations.

The Nature of Unrealized Securities Losses

Unrealized losses occur when the market value of securities held by banks, such as bonds, falls below their book value due to rising interest rates. The OFR notes that these losses are particularly significant for securities classified as Available-for-Sale (AFS) or Held-to-Maturity (HTM). For AFS securities, unrealized losses directly affect equity through Accumulated Other Comprehensive Income (AOCI), reducing Tier 1 capital. HTM securities, while not impacting capital unless sold or impaired, can pose liquidity risks if banks need to liquidate these assets at a loss.

The OFR data indicates that small and mid-sized banks are disproportionately affected, with unrealized losses representing a larger share of their capital. This vulnerability is compounded by the fact that many banks have extended the duration of their securities portfolios, increasing their sensitivity to interest rate changes. As interest rates rose sharply in 2022–2024, the economic value of these portfolios declined, creating a significant challenge for bank balance sheet management.

Linking Unrealized Losses to IRRBB

The BCBS’s IRRBB framework, detailed in the document SRP98: Application Guidance on Interest Rate Risk in the Banking Book (effective December 2019), provides a structured approach to managing the risks highlighted by the OFR. IRRBB is defined as the risk to a bank’s capital and earnings from adverse interest rate movements affecting its banking book, which includes securities portfolios. The framework emphasizes two key metrics:

1. Economic Value of Equity (EVE): This measures the change in the net present value of the banking book under various interest rate shock scenarios. Unrealized losses on securities directly reduce EVE, as the market value of fixed-rate securities declines when rates rise. The BCBS prescribes six standardized shock scenarios (e.g., parallel up/down, steepener, flattener) to assess this impact, ensuring banks evaluate both parallel and non-parallel yield curve shifts.
2. Net Interest Income (NII): This captures the short- to medium-term impact of rate changes on earnings. While unrealized losses on securities do not immediately affect NII, they can constrain a bank’s ability to generate income if capital buffers are eroded, limiting lending or investment opportunities.

The BCBS framework identifies three main sub-types of IRRBB—gap risk, basis risk, and option risk—all of which are relevant to unrealized securities losses:

• Gap Risk: Arises from mismatches in the repricing of assets and liabilities. Securities with longer durations, common in bank portfolios, are highly sensitive to rate changes, leading to significant EVE declines when rates rise, as seen in the OFR’s findings.
• Basis Risk: Occurs when assets and liabilities are priced off different indices. For example, securities tied to Treasury yields may not align with funding costs tied to other benchmarks, amplifying losses in a rising rate environment.
• Option Risk: Embedded options in securities (e.g., callable bonds) can exacerbate losses if exercised unfavorably due to rate changes. The BCBS distinguishes between automatic and behavioral options, with the latter requiring complex modeling to predict customer behavior.

Regulatory Implications and Bank Responses

The BCBS IRRBB guidelines require banks to measure and monitor these risks using both EVE and NII metrics, with stress testing to assess vulnerabilities under severe scenarios. Banks must also maintain adequate capital buffers to absorb potential losses, as outlined in the Central Bank of Bahrain’s IRRBB Module (2024), which aligns with BCBS standards. The Bahrain framework mandates that banks notify regulators if the change in EVE exceeds 15% of Tier 1 capital, a threshold that could be triggered by significant unrealized losses in a high-rate environment.

To mitigate these risks, banks can adopt several strategies outlined in the BCBS framework:

• Hedging: Using interest rate derivatives, such as swaps, to offset the impact of rate changes on securities portfolios. The BCBS emphasizes controlling mark-to-market risks for instruments accounted at fair value, which is critical for AFS securities.
• Portfolio Rebalancing: Shortening the duration of securities holdings to reduce sensitivity to rate changes, though this may involve realizing losses on existing positions.
• Behavioral Modeling: Accurately modeling the behavior of non-maturity deposits (NMDs) and prepayment risks, as these can amplify IRRBB. The BCBS provides detailed guidance on slotting NMDs into time buckets based on their stability, which helps banks manage gap risk.
• Stress Testing: Regularly testing portfolios against the six BCBS-prescribed shock scenarios to identify vulnerabilities. The OFR’s data suggests that many banks may need to enhance their stress testing to account for the scale of unrealized losses.

Challenges and Future Outlook

The OFR highlights that unrealized losses remain a concern as long as interest rates stay elevated or continue to rise. The BCBS framework acknowledges the complexity of managing IRRBB, particularly for smaller banks with limited resources for sophisticated modeling. These banks may struggle to implement the standardized approach required by regulators like the Central Bank of Bahrain, which demands detailed cash flow bucketing and scenario analysis.

Moreover, the BCBS notes that economic value losses do not always translate to accounting losses, especially for HTM securities. However, the OFR’s analysis suggests that prolonged high rates could force banks to sell these securities to meet liquidity needs, crystallizing losses and impacting capital. This scenario underscores the need for proactive IRRBB management, including robust governance and validation frameworks as mandated by the Bahrain Rulebook.

Looking ahead, banks must balance the trade-off between earnings stability and economic value risk, as noted in the BCBS document. Investing in short-term securities may reduce EVE risk but increase earnings volatility, while long-term fixed-rate securities lock in income but expose banks to significant unrealized losses. The OFR’s data serves as a wake-up call for banks to align their strategies with IRRBB regulations, ensuring they can withstand further rate hikes or economic stress.

Implications for Regulators Worldwide, Particularly in Emerging Markets

The $500 billion in unrealized securities losses reported by the OFR has significant implications for regulators worldwide, especially in emerging markets where banking systems often face unique challenges. The BCBS IRRBB framework, while globally applicable, poses both opportunities and challenges for regulators in these jurisdictions.

1. Strengthening Supervisory Oversight: Regulators must enhance oversight to ensure banks implement the BCBS’s standardized approach for EVE and NII calculations. In emerging markets, where data availability and modeling expertise may be limited, regulators like the Central Bank of Bahrain have mandated simplified approaches for smaller banks within the Internal Capital Adequacy Assessment Process (ICAAP). However, ensuring compliance with the six prescribed shock scenarios requires investment in supervisory capacity and training.
2. Capital Adequacy Challenges: Emerging market banks often operate with thinner capital buffers compared to their developed market counterparts. The BCBS’s 15% EVE-to-Tier 1 capital threshold for identifying outliers may be particularly stringent for these banks, as unrealized losses could quickly erode capital. Regulators may need to balance stricter capital requirements with the risk of stifling credit growth, which is critical for economic development in these regions.
3. Currency-Specific Risks: The BCBS framework accounts for currency-specific interest rate shocks, which is crucial for emerging markets with volatile local currencies. For instance, the Central Bank of Bahrain’s IRRBB Module specifies shock sizes for the Bahraini Dinar (BHD), such as 200 basis points for parallel shocks. Regulators in other emerging markets, like Brazil or India, must tailor these shocks to local conditions, as highlighted in the BCBS’s use of historical data from 2000–2015 to calibrate currency-specific scenarios.
4. Implementation Gaps: Unlike developed jurisdictions like the Euro area or Canada, which have fully implemented the BCBS IRRBB standards, emerging markets often lag due to resource constraints. A 2023 Yale School of Management study notes that the U.S. has not fully adopted the BCBS framework, and similar gaps exist in emerging markets. For example, African countries (except South Africa) have struggled to move beyond Basel I or II, as noted in a 2016 Capital Markets in Africa report. This delay increases vulnerability to interest rate shocks, particularly for banks with significant securities holdings.
5. Data Availability in Other Jurisdictions: Similar data on unrealized securities losses is less readily available in emerging markets, but some jurisdictions provide insights. In the Euro area, the European Central Bank’s 2023 Annual Report notes that banks faced rising deposit rates and increasing non-performing loans due to higher interest rates, though unrealized losses were not quantified. In South Africa, a 2023 study on BRICS banking sectors found that rising interest rates exacerbated credit risk, suggesting potential unrealized losses in securities portfolios. In India, the Reserve Bank of India’s 2024 Financial Stability Report highlighted that banks’ mark-to-market losses on bond portfolios increased due to yield curve shifts, though specific figures were not disclosed. These examples indicate that unrealized losses are a global concern, but emerging markets often lack the granular data seen in the OFR’s U.S. analysis.
6. Policy Recommendations: Emerging market regulators should prioritize capacity building to implement BCBS standards, leveraging technical assistance from institutions like the IMF or World Bank. Adopting simplified IRRBB methodologies, as seen in Bahrain, can help smaller banks comply without overwhelming resources. Additionally, regulators should encourage banks to diversify funding sources and reduce reliance on long-duration securities, which are prone to gap risk. Public disclosure requirements, as mandated by the BCBS and Bahrain’s Rulebook, can enhance market discipline but must be balanced with the risk of triggering panic in less mature financial markets.

Conclusion

The $500 billion in unrealized securities losses reported by the OFR is a stark reminder of the risks posed by interest rate fluctuations, a core focus of the BCBS IRRBB framework. By adhering to the BCBS guidelines, banks can better measure, monitor, and mitigate these risks through rigorous stress testing, prudent hedging, and strategic portfolio management. Regulators like the Central Bank of Bahrain reinforce these standards, ensuring banks maintain adequate capital and governance to safeguard financial stability. For emerging markets, adopting the IRRBB framework is critical but challenging due to resource constraints and data gaps. As interest rates remain a key driver of bank performance, integrating IRRBB principles into risk management will be crucial for navigating the challenges ahead, particularly in jurisdictions where unrealized losses could destabilize banking systems.

References

Office of Financial Research. “The State of Banks’ Unrealized Securities Losses.” The OFR Blog, May 15, 2025. https://www.financialresearch.gov/the-ofr-blog/2025/05/15/the-state-of-banks-unrealized-securities-losses/.

Annex: Glossary of Terms

• Accumulated Other Comprehensive Income (AOCI): A component of equity that includes unrealized gains and losses on Available-for-Sale securities, affecting Tier 1 capital.
• Available-for-Sale (AFS) Securities: Financial assets that banks intend to hold for an indefinite period but may sell in response to market conditions, valued at fair value with unrealized gains/losses recorded in AOCI.
• Basis Risk: The risk arising from the imperfect correlation in the adjustment of interest rates on assets and liabilities priced using different indices.
• Economic Value of Equity (EVE): A measure of the net present value of a bank’s banking book under various interest rate scenarios, reflecting the impact of rate changes on capital.
• Gap Risk: The risk arising from mismatches in the repricing schedules of assets and liabilities, affecting their economic value when interest rates change.
• Held-to-Maturity (HTM) Securities: Financial assets that a bank intends to hold until maturity, valued at amortized cost and not subject to mark-to-market adjustments unless sold or impaired.
• Interest Rate Risk in the Banking Book (IRRBB): The risk to a bank’s capital and earnings from adverse movements in interest rates affecting its banking book.
• Net Interest Income (NII): The difference between interest income earned on assets and interest expense paid on liabilities, reflecting a bank’s short- to medium-term earnings sensitivity to rate changes.
• Non-Maturity Deposits (NMDs): Deposits with no contractual maturity date, such as savings accounts, which require behavioral assumptions to assess their interest rate sensitivity.
• Option Risk: The risk arising from embedded options in financial instruments, which can alter cash flows based on interest rate changes, divided into automatic and behavioral sub-types.
• Tier 1 Capital: A bank’s core capital, including common equity and disclosed reserves, used to absorb losses and meet regulatory requirements.