The banking system has shown steady signs of improved stability during the past two years, but it is not out of the woods yet, according to research from the Federal Reserve Bank of Dallas.
Unrealized losses on securities holdings remain a drag on tangible capital ratios and troubled assets — namely commercial real estate loans — are a point of vulnerability for many banks, according to a
The study looked at publicly available information from the financial disclosures of roughly 4,500 banks from the beginning of 2019 through the end of 2024. For each of these banks, it examined four
According to the report, a little more than 13% of banks were flagged as risky in at least one of those four categories during the fourth quarter of 2024, accounting for roughly 17.5% of assets in the banking system. That was the lowest year-end risk reading since 2021, when roughly 12% of banks — by number and asset size — had at least one risk flag.
Still, the most recent risk reading remains well above the pre-pandemic distressed rate of roughly 8% in 2019.
The biggest driver of risk in the banking system today, according to the report, is banks' adjusted tangible capital equity, which reflects their regulatory capital holdings minus unrealized losses on both available-for-sale and held-to-maturity securities. These paper losses are high because so many banks invested in Treasuries and mortgage-backed securities during the early phase of the COVID-19 pandemic.
Flush with deposits from customers who were plied with stimulus money and accumulated savings, banks invested heavily in securities in 2020 and 2021. This rapid expansion of assets was the driving force for risk during those years, the report states.
But once the Fed began raising interest rates in 2022, the value of those assets declined relative to newer, higher-yielding securities, cratering demand for significant portions of their securities portfolios. As a result, low adjusted capital went from being a flag for effectively no banks at the end of 2021 to 11% of banks — accounting for nearly 26% of banking assets — at the end of 2022.
These declining securities valuations played a key role in the
The share of banks struggling with lower adjusted capital has fallen to less than 5%, but it remains an issue for a relatively small number of large banks. As a result, the share of assets within banks with adjusted capital ratios is more than 15%. This dynamic reflects the overall share of risk flags in the banking sector skewing toward larger institutions.
"In the fourth quarter of 2024, the largest banks had the largest percentage exposures to the risk indicators," the report notes. "Banks in the smallest and largest size bands have higher percentage exposures than before the pandemic, while banks in the two middle groupings have lower exposures."
The report noted that the issues relating to paper losses are an area to watch during the Fed's "higher-for-longer" approach to monetary policy. But those issues are likely to dissipate if interest rates were to fall again.
