The Silent Threat to Banks: Unrealized Losses and the Fragile Future of Deposit Insurance
The collapse of Silicon Valley Bank (SVB) in March 2023 wasn’t an isolated incident; it was a stark warning. While the immediate trigger was a classic bank run, the underlying vulnerability stemmed from a far more insidious problem: massive, hidden losses on banks’ assets. As interest rates surged, the value of those assets plummeted, creating a precarious situation masked by accounting rules. New research reveals that while European banks fared better than their US counterparts, they aren’t immune, and a surprisingly small outflow of deposits could trigger instability. This isn’t just a problem for bankers; it’s a systemic risk that could impact everyone.
The Mismatch Game and the Deposit Franchise
Banks operate on a fundamental imbalance: they borrow short-term (deposits) and lend long-term (loans and bonds). This “maturity transformation” is profitable when interest rates are stable, but dangerous when they rise. Higher rates erode the market value of long-dated assets. However, banks benefit from a “deposit franchise” – the ability to pay depositors less than prevailing market rates. This franchise becomes more valuable as rates rise, acting as a natural hedge. But this hedge is only effective if depositors stay put.
Recent analysis by Rice and Guerrini (2025) confirms that banks exploit this deposit franchise, lengthening the maturity of their assets, particularly those with ‘sticky’ deposits. However, the very mechanism that provides a buffer also creates a vulnerability. As unrealized losses grow alongside the deposit franchise, confidence is the key. A loss of confidence can trigger a run, destroying the franchise precisely when it’s most needed – a dynamic vividly illustrated by the SVB failure.
Europe’s Resilience… and Hidden Risks
A study examining 139 euro area banks reveals a more stable, but not invulnerable, situation compared to the US. By September 2023, unrealized losses averaged around 30% of book equity, peaking at 60% for some institutions. This contrasts sharply with the US, where losses averaged 75-95% of equity, and some banks exceeded SVB’s loss levels (Jiang et al., 2024).
This difference isn’t due to superior risk management, but structural factors. US banks hold three times more long-dated debt securities, making losses more visible. Europe’s mortgage market is also more diverse, with variable-rate mortgages mitigating the impact of rising rates on loan portfolios. Banks in countries with variable rates saw minimal impact on their loan values while still benefiting from the expanding deposit franchise. In fact, one in six euro area banks saw their net worth increase as rates rose, thanks to this dynamic.
Who’s Most Vulnerable?
The impact of rising rates wasn’t uniform. Smaller retail lenders with long-dated mortgages and limited use of interest rate swaps (IRS) were hit hardest. Larger banks, actively using swaps to hedge their positions, experienced losses primarily on their bond holdings. Swaps absorbed roughly one-fifth of unrealized losses in the euro area, with pension funds playing a crucial role as counterparties – a relationship that warrants close monitoring (more on that later).
Simulating the Unthinkable: Deposit Run Scenarios
To gauge the potential for an SVB-style collapse, researchers simulated deposit runs, calculating the outflow of uninsured deposits needed to render banks insolvent on a market-value basis. The results are sobering. While the average bank appears resilient, a 5% outflow of uninsured deposits would have pushed three euro area banks into insolvency by September 2023. A 10% outflow would have impacted 26 banks. While less severe than the US, the risk is undeniably present. A single bank failure could trigger a broader panic, especially in a less favorable economic climate.
The Future of Banking: Key Vulnerabilities and Policy Implications
The recent monetary cycle highlighted several critical vulnerabilities. The deposit franchise, while stabilizing, encourages banks to take on more interest rate risk. Supervisors must scrutinize banks heavily reliant on this franchise while holding long-duration assets without adequate hedging. Furthermore, the fragmented nature of European deposit insurance is a major weakness. A fully-fledged European Deposit Insurance Scheme (EDIS) is crucial to prevent a “first-mover advantage” in a run, where depositors rush to withdraw funds from perceived weaker institutions.
The interconnectedness of the swap market also demands attention. The concentration of counterparties – primarily pension funds – amplifies systemic risk, as demonstrated by the UK’s 2022 LDI crisis. Macroprudential surveillance must map the network of swap positions, not just individual bank exposures. Finally, the speed of digital finance – mobile banking and instant transfers – dramatically compresses run durations, requiring real-time monitoring of retail flows and revised liquidity coverage ratio assumptions.
The euro area banking system demonstrated resilience, but pockets of fragility remain. Diversity in asset durations, funding mixes, and hedging strategies limited the damage. However, this diversity also means some banks are significantly more exposed than others. The future of banking hinges on addressing these vulnerabilities proactively.
What will happen as digital channels continue to reshape depositor behavior? Will pension reforms erode the counterparties for banks’ swap hedges? And, crucially, can a pan-European deposit insurance scheme be established before the next economic cycle turns? These are the questions that will define the stability of the financial system in the years to come.
Explore further insights into financial stability risks from the European Central Bank.
Share your thoughts on the future of banking and deposit insurance in the comments below!
