Contagion Risks: A Level-Headed Assessment

 | Mar 14, 2023 02:21PM ET

If a couple of regional banks were so bad at managing their interest rate risk and deposit outflow risk to blow up in a few hours, how can we really be sure other banks won’t face similar problems?

Having run a large investment portfolio at a European bank and been part of the management for the Treasury department, I will try to use my practical experience.

Banks buy bonds for two main reasons: clipping coupons and regulation.

When you attract deposits and do nothing on the asset side, you are going to accumulate reserves at your domestic Central Bank.

But banks want to make money, and bonds generally yield more than Central Bank reserves (chart below).

Sum up regulation (LCR) forcing large banks to own ~20% of their balance sheet in liquid assets (read: bonds) and there you go: banks have huge investment portfolios to clip coupons and meet regulation.