The 10-year Treasurys and mortgage-backed securities (MBSs) typically backed by the federal government, are considered safe holdings. But as with all bonds, their values on open markets can fluctuate, with prices and yields moving inversely to one another. When bond yields climb, as they do when the Federal Reserve increases interest rates, prices drop. The bonds the banks hold become worth less than they were.

But banks keep these bonds in two categories as set by accounting standards: hold-to-maturity (HTM) and available-for-sale (AFS). In the first case, the assumption is that the institution will hold the bonds until they are fully redeemed. In the second case, the holder can sell the bonds whenever it wishes. But AFS bonds are marked to market and can change value. Bonds taken out of the HTM category get revalued to current market conditions. The trouble sets in given that many purchases of bonds occurred with very low interest rates and now have lost a lot of value.

"The U.S. banking system's market value of assets is $2 trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity," wrote the researchers. "Marked-to-market bank assets have declined by an average of 10% across all the banks, with the bottom 5th percentile experiencing a decline of 20%."

SVB had a large loss of financial value unrecognized in its accounting because the bonds were HTM category. When there was a run of customers trying to pull their deposits out, SVB didn't have the liquidity — lacked the cash to cover the withdrawals. It tried to sell the bonds, but those were then marked down in value and SVB officially didn't have enough money to cover its obligations, so it went from illiquid to insolvent.

A tenth of all banks have unrecognized losses larger than SVBs, according to the researchers. Also, 10% of all banks — not necessarily the same 10% — have worse capitalization than SVB did.

Heavily Uninsured Deposits

Now comes the second issue: uninsured deposits. FDIC insurance only covers the first $250,000 deposited in an account. It is possible to go beyond the limit with multiple accounts, like having a personal and business account, which are considered separately, or accounts in separate banks. But many depositors don't use such mechanisms. That was the case with the high concentration of tech startups doing business with SVB, in which 92.5% of deposits were uninsured. Only 1% of banks have higher portions of uninsured deposits.

But the combination of lost value and high uninsured portions of deposits are a dangerous mix. The former reduces the ability of an institution to cover deposits, while the latter provides the conditions in which fear might drive many depositors to pull their funds and move them to another bank, presumably a larger one more likely to be able to keep them safe.

"We compute similar incentives for the sample of all U.S. banks," the researchers said. "Even if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment to insured depositors, with potentially $300 billion of insured deposits at risk. If uninsured deposit withdrawals cause even small fire sales, substantially more banks are at risk. Overall, these calculations suggest that recent declines in bank asset values very significantly increased the fragility of the US banking system to uninsured depositor runs."

And yet, the challenge facing the Federal Reserve is that lowering interest rates could ignite new rounds of inflation and stoke a different economic danger.