The High-Stakes Gamble of Bank Performance

The recent surge in long-term Treasury yields has set off a chain reaction in the banking landscape, leaving many institutions scrambling to adapt to changing market conditions. As banks adjust to this new reality, those with stable deposits and short-duration assets will reap the rewards, while those with fragile funding and fixed-rate books will struggle to keep up.

The surge is not a zero-sum game, where some banks win at the expense of others. Rather, it’s a stark reminder that the banking industry’s performance is inextricably linked to broader economic trends – and that those trends are often beyond the Fed’s control. The scale of U.S. debt, the ongoing war in Ukraine, and tariff uncertainty have all contributed to the upward trajectory of yields.

Banks with plenty of floating-rate commercial loans, cheap core deposits, short-duration securities, and little long-duration fixed-rate lending will benefit from higher interest income. This has led to a surge in net interest income and potentially even higher margins. For example, if a bank makes a new commercial loan at 7% or buys a Treasury at 5%, it earns significantly more than it did during the low-rate years.

However, this windfall is short-lived. When Treasury yields rise, customers can earn attractive returns elsewhere – such as in money-market funds, T-bills directly, or by demanding higher CD rates from their current bank. This spells trouble for banks with unstable deposits and fragile funding, which may struggle to maintain profitability as depositors reprice and margins get squeezed.

The decline in value of existing Treasury holdings is a pressing concern for banks. Silicon Valley Bank’s experience serves as a reminder: if a bank bought a 10-year Treasury at 2% and today’s 10-year yields 4.7%, that old bond would be worth substantially less, even though it still pays its coupons and matures at par.

This phenomenon is not unique to SVB; the Federal Reserve has flagged significant unrealized losses in banks’ available-for-sale portfolios – a staggering $182 billion below book value at the end of 2024. As long-term yields continue to climb, those losses could grow again, posing a major capital problem for banks with long-duration assets and unstable deposits.

There are two distinct types of banks: those with short-duration assets and stable deposits, and those with long-duration assets and fragile funding. The former will thrive as interest income surges and depositors reprice, while the latter will struggle to keep up with rising costs and falling asset values. This dichotomy speaks to a fundamental flaw in many banks’ business models: focusing on short-term gains and ignoring the risks of long-duration assets.

While the current surge in Treasury yields poses challenges for some banks, it also presents an opportunity for those willing to adapt and rebuild their portfolios at higher yields. As old low-yield assets mature and are replaced with higher-yield ones, that can offset a meaningful share of the mark-to-market losses.

However, this requires a nuanced understanding of the yield curve’s shape – not just its level. A steepening curve tends to be beneficial for banks, as it means funding costs remain low while lending at higher long-term rates becomes more attractive. Conversely, a flat or inverted curve can be disastrous, forcing banks to charge more for loans but facing reduced demand.

The banking industry must grapple with these new realities: high Treasury yields are a double-edged sword, capable of both boosting profits and triggering losses. By understanding this dynamic, we can better appreciate the high-stakes gamble that bank performance has become – and what it means for their future prospects.