The hidden risk on bank balance sheets
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Capital adequacy standards are set by governments, and governments want to make sure they can borrow money as easily and cheaply as possible.
Why it matters: As a result, one of the biggest risks to banks is generally overlooked under Basel rules.
The big picture: Government bonds have a zero risk weighting under Basel rules, which means that banks can hold an unlimited quantity of them without having to hold any capital at all.
The catch: Government bonds might not have any credit risk (although, in this era of debt-ceiling standoffs, even that isn't certain anymore), but that hardly means they're risk-free.
- In fact, interest-rate risk — something common to all bonds, including government bonds — is a bigger risk than credit risk.
By the numbers: Roboadvisor Wealthfront has a new bond portfolio that's designed to have annualized volatility of no more than 3%. It can include a small quantity of high-risk bonds — junk bonds, for instance, have an estimated volatility of 12.2%, while emerging-market bonds stand at 12.4%.
- The highest-volatility asset class of all, however, is long-term Treasury bonds, which have a volatility of 14.5%.
- The 1.25% Treasury bond maturing in May 2050, for instance, traded at more than 101 cents on the dollar in August 2020. By October 2022, you could buy the same bond for less than 50 cents. If a bank owned that bond, its balance sheet could have been severely damaged by such a move.
Between the lines: That, more or less, is what happened to Silicon Valley Bank. It invested huge amounts of money into government-guaranteed mortgage bonds, and then collapsed when those bonds fell in value.
The bottom line: Bank capital rules are designed to keep banks safe. But with long-dated government bonds retaining a zero risk weighting, they won't really reflect the true risks on banks' balance sheets.
