2022 Year-End Message from Governor Bowman
by Governor Michelle W. Bowman
As we begin 2023, I would like to recognize community bankers across the country and their ongoing efforts to support communities as we continue to confront the challenges that lie ahead. Over the past year, we have enjoyed a return to pre-pandemic life and a resumption of business as usual, at least as it exists today. I have found it energizing and informative to finally resume in-person speaking engagements and meetings with bankers throughout the nation. These interactions have enabled us to facilitate an open and active dialogue about the issues and emerging risks affecting community banks, the financial services industry, and the broader economy. This New Year's message provides a view of the current economic conditions and the Federal Reserve's supervisory posture in light of these conditions.
As of year-end 2022, the financial condition of banks generally remains sound, with improvement in net interest margin and low delinquencies in most loan categories. However, current economic conditions, particularly inflation and rising interest rates, could pose challenges to some aspects of these conditions.
First, as we know, inflation affects both businesses and consumers. High inflation disproportionately affects lower- and middle-income households whose wages are eroded by the higher costs of everyday goods and services. High inflation also makes it difficult for businesses to plan and to conduct their core activities as the costs of inputs rise. As a member of the Federal Open Market Committee (FOMC), I am committed to bringing down the unacceptably high inflation American households and businesses have been experiencing. Throughout 2022, I supported the FOMC's actions to increase the federal funds rate in our effort to bring down inflation. Since the beginning of last year, we increased the target range for the federal funds rate by 4¼ percentage points and began the process of decreasing the size of our balance sheet through the runoff of our securities holdings.
My views on the appropriate size and pace of future rate increases and on the ultimate level of the federal funds rate will continue to be guided by the incoming data and the outlook on inflation and economic activity. I will be looking for signs that inflation has peaked and appears to be on a consistently downward path in determining both the appropriate size of future rate increases and the level at which the federal funds rate is sufficiently restrictive to bring down inflation. I expect that the federal funds rate will need to remain at a sufficiently restrictive level for some time in order to restore price stability, which will in turn help to create conditions for a sustainably strong labor market. Maintaining a steadfast commitment to restoring price stability is the best way to support a sustainably strong labor market for all Americans.
The increases in the federal funds rate have significantly changed the interest rate environment for community banks. Generally, community banks continue to be in stable financial condition and serve as a source of strength to their communities. While we don't yet know how the future interest rate environment and economic conditions may evolve, many banks have been actively preparing for a range of possible future conditions. Many small banks are positioned to benefit from the rising rate environment. At that same time, some banks are reporting unrealized losses on the fair value of their available-for-sale securities, resulting in a lower or negative tangible common equity.
Over the past two years, many banks purchased securities with extended maturities to enhance earnings. This strategy supported net interest income while interest rates and loan demand remained low. As interest rates have risen, the book value of these investment securities has declined. In a small but growing number of banks, these losses are eroding tangible common equity, even though for most banks the losses do not directly impact regulatory capital levels.
Nevertheless, banks with unrealized securities losses need to carefully consider the potential impact of holding securities with below-market interest rates, including, among other things, the impact on their liquidity, capital, and earnings. Unrealized losses can strain banks' liquidity, as the lower market value of their securities may require banks to pledge a greater number of securities as collateral, which in the aggregate can reduce their borrowing capacity. Likewise, banks' sale of securities with unrealized losses to meet funding needs would result in the realization of those losses and would negatively impact their regulatory capital. In addition, these depreciated securities could result in lower earnings due to yields below current market rates on some longer-dated securities. This environment presents potential challenges including how to best manage the unrealized losses and the associated risks to liquidity, earnings, and capital.
This brings me to the Federal Reserve's supervisory posture in light of current economic conditions. Bankers should expect an open dialogue with our examiners as they monitor and assess this impact on member banks. I want to emphasize that there is nothing substantively different in our supervisory approach. There is no new guidance or rulemaking on interest rate risk management. That said, it is important for bankers to consider current economic conditions in their liquidity and capital planning process and proactively address the full spectrum of risks. For instance, banks should be closely monitoring deposit behavior and update assumptions in their interest rate risk and liquidity measurement tools to ensure that they have sufficient contingent funding sources.
We do expect that most banks should be able to manage unrealized losses in the normal course of business. For these banks, the value of their securities will return to par value as the underlying securities approach maturity. Therefore, bankers need to have a sound understanding of the risks associated with large unrealized losses and, where applicable, negative tangible common equity. Supervisors expect management to take proactive measures to mitigate potential risk exposures.
I want to emphasize that Federal Reserve examiners will not criticize a bank based solely on unrealized losses in available-for-sale securities and the corresponding reduction in the tangible common equity ratio. Our examiners are expected to assign supervisory ratings that reflect a bank's current condition and the impact of unrealized losses on securities on the bank's liquidity, sensitivity to market risk, earnings, and capital. Further, examiners will consider whether risk management practices are adequate to address the elevated risks from unrealized losses in the securities portfolio. For example, a bank with a liability duration structure similar to its assets may not present a supervisory concern.
Based on the results of off-site monitoring, examiners may reach out to bankers to better understand their risk management strategies. From a supervisory perspective, we expect that a bank's risk management practices are consistent with safe-and-sound risk management principles and evolve as conditions warrant.
In keeping with my commitment to transparency regarding our supervisory expectations, we recently held an Ask the Fed session to discuss our supervisory expectations for banks with falling bond portfolio values and declining or negative tangible common equity. If you missed this Ask the Fed session, a recording of it is available at www.askthefed.org. I also encourage you to reach out to your Reserve Bank point of contact who would be in the best position to address specific questions about your bank.
In closing, I look forward to seeing many of you at industry events throughout 2023. As always, I encourage you to contact me or our Federal Reserve staff to answer questions or to share your feedback and ideas.