ECB Paper Highlights How “Hidden Losses” Amplify Rate Hikes’ Impact on Lending
SDG 8: Decent Work & Economic Growth | SDG 16: Peace, Justice & Strong Institutions
Institutions: Reserve Bank of India | Ministry of Finance
The ECB’s working paper “Hidden Weaknesses: The Role of Unrealized Losses in Monetary Policy Transmission” explores how unrealized losses-i.e. declines in market value not yet reflected in accounting books-on debt securities held by banks can worsen the effect of monetary tightening (raising interest rates) on bank lending.
The paper notes that banks often classify bonds and loans under amortized cost accounting-an approach where assets are carried at their original purchase price, adjusted for repayments and interest, instead of reflecting daily market values. While this shields earnings in the short term, it masks risks: when rates rise sharply, these hidden losses reduce the economic value of equity, weaken banks’ balance sheets, tighten funding conditions, and make banks more cautious about extending credit-especially for smaller firms.
The authors quantify that a 1 percentage point increase in a bank’s share of unrealized losses amplifies the drop in new lending by ~1 pp, especially in banks with weaker capital, lower liquidity, or reliance on uninsured deposits.
In India, banking systems and NBFCs frequently maintain portfolios of long-term securities (e.g. government bonds, corporate debt). Sharp rate cycles could similarly expose “hidden” losses, compress credit flows, and disproportionately impact smaller borrowers. It becomes crucial for RBI and regulators to monitor unrealized exposures, require stronger buffers, and possibly stress-test for such hidden risks.
What is an Unrealized Loss? → It’s a decline in the market value of a security that the holder hasn’t yet sold. The loss is “on paper” until realised (i.e. sold).
What is Amortized Cost? → Amortized cost is an accounting method where financial assets (like bonds or loans) are recorded at their purchase price, adjusted over time for repayments and interest, instead of being marked daily to current market value. It smooths earnings but can hide risks when market prices fall.
Follow the full paper here: ECB Working Paper 3129