A sharp rise in bond yields over the past few weeks has threatened recovery in the balance sheets of global banks, according to a report by Tom Braithwaite and Patrick Jenkins of the Financial Times. Interest rates surged last week after Federal Reserve chief Ben Bernanke announced the Reserve would trim the asset purchase program by the end of this year.

Bond Yields

Global banks have accumulated large portfolios of liquid securities, mainly due to regulatory requirements. Banks are also unable to find better opportunities to lend the accumulating deposits. Under the new rules, unrealized losses on the “available for sale” portfolios will hit the banks’ equity capital. Bankers have complained that limits on leverage and higher capital requirements have affected their ability to lend.

Banks Vulnerable to Rising Bond Yields

The Financial Times says that the current composition of banks’ balance sheets is such that banks become vulnerable to an increase in interest rates. For example, about 90 percent of Bank of America Corp. (NYSE:BAC)’s $315 billion securities portfolio is invested in Treasuries and mortgage-backed securities. As bond yields surge, prices decline.

According to the Federal Reserve, the unrealized gains from “available for sale” portfolios have plummeted to $16.7 billion. That’s more than a 50 percent decline in just two months. Richard Tang, RBS Securities’ chief of North America sales, said that despite the spike in Treasury yields, there hasn’t been a steep yield curve that boosts profits for banks. Banks usually look for steepening of the yield curve to borrow at lower rates on a short-term basis, and lend at higher rates in the longer term.

Rising Bond Yields May Prove Beneficial in Certain Cases

Banks are gearing up to report their second quarter earnings. The Financial Times believes that some major banks may report losses. The decline in the value of large AFS portfolios isn’t reflected in income immediately, but may affect book value under the new rules. However, some economists argue that the negative effects of crumbling asset values will be more than compensated by the interest rate margin increases.

Deutsche Bank said in a research report that whether an increasing interest rate is good or bad for banks is decided by the magnitude of  increase, and the flattening or steepening of the curve. Deutsche Bank analyst Matt O’Connor said that an increase of 100 basis points in interest rates will be beneficial for banks as it will add 15-20 basis points to net interest margins without meaningfully hitting the book value. But a 300bp increase in long-term rates will badly hit the book value/capital of banks.