Bond Yields Threaten Recovery in Global Banks’ Balance Sheets

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The recovery in global banks' balance sheets is under threat from a surge in bond yields, according to senior bank executives and analysts preparing for quarterly earnings season.

Banks have built giant portfolios of liquid securities, partly at the behest of regulators and also because they have not found better opportunities to lend a flood of deposits. Under new capital rules, unrealized losses in these "available for sale" portfolios hit banks' equity capital.

(Read More: Bond Losses of $1 Trillion if Yields Spike, BIS Says)

"I would think most institutions are going to have a fairly sizeable hit to their equity," said a senior executive of a top U.S. bank. "You've really had this concentrated one-to-two week period where all hell is breaking loose."

The composition of the balance sheets leaves banks vulnerable to the spike in interest rates. For example, Bank of America has a $315 billion securities portfolio, 90 percent of which is invested in mortgage-backed securities and Treasurys. As yields rise, prices fall.

(Read More: Why the Rise in Treasury Yields May Be OK)

In the U.S., the unrealised net gains on "available for sale" portfolios has slumped to $16.7 billion, its lowest level in two years, according to the latest Federal Reserve data. The metric tracks the performance of banks' AFS portfolios, largely comprised of mortgage-backed securities and Treasuries, and the fall represents a drop of more than 50 percent in two months.

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It comes after yields on the benchmark 10-year Treasury have risen to their highest level in almost two years and last week jumped by the biggest percentage in a decade as Ben Bernanke, Fed chairman, indicated that the central bank might scale back its bond-buying program known as quantitative easing. On Tuesday, yields on the 10-year Treasury benchmark rose 3 bps to about 2.58 percent.

Richard Tang, head of North America sales at RBS Securities, noted that despite the rise in 10-year Treasury yields, there had not been a steepening of the yield curve that would help drive profits. Banks generally prefer a steep yield curve because they like to borrow on a short-term basis at low rates and lend longer-term at higher rates. He added: "There could be some nasty losses."

(Read More: Great Rotation? Not Yet, but Watch Those Yields)

Some trading portfolios could report losses immediately when banks begin reporting second-quarter earnings in two weeks. The fall in value of larger AFS portfolios is not immediately reflected in income but does hit tangible book values under new Basel III capital rules.

Some commentators are convinced that the harm done to bank balance sheets by crumbling asset values will be more than offset by the prospective interest margin increases that should come with phased-out monetary easing.

Analysts at Morgan Stanley wrote in a note to clients on Tuesday: "We are solidly in the bull camp . . . We see the benefit of higher rates outweighing a one-time hit to [book values]."

But other analysts and bank executives warn that the transition could be painful. "Longer term, once things settle and we price in a non-QE world, I think it's ultimately better for the banks from a net interest margin perspective and a market volatility perspective," said Mr Tang. "The only problem is the near term could get uglier before it gets better."

(Read More: Market Consensus: Get Ready for 3% Treasury Yields)

Standard Chartered, which will update investors on Wednesday about its second-quarter performance, is expected to welcome the tightening of U.S. monetary policy. Commenting on a relatively weak first-quarter performance last month, chief executive Peter Sands blamed monetary policy in the US and Japan for making cheap dollar funding available to local competitors – eroding margins as a result.

One European bank boss said: "There will be a benefit from higher interest margins and the extra business opportunities that come from a new period of volatility."

"But overall, taking into account the hit to asset prices, I think the impact will be slightly negative."