The Quiet Erosion: Why Unrealized Losses Could Undermine the ECB’s Fight Against Inflation

The European Central Bank’s working paper “Hidden Weaknesses: The Role of Unrealized Losses in Monetary Policy Transmission” (ECB Working Paper No. 3129), authored by Sebastian J. Schmidt of the European Central Bank and Benedikt Fritz of the University of Cologne, sheds light on an invisible fragility within Europe’s banking system. The joint research by the ECB and the University of Cologne reveals how unrealized losses, declines in the market value of securities that banks hold but have not sold, can quietly weaken the channels through which monetary policy operates. Far from being an abstract accounting issue, these losses can have tangible consequences for credit supply, financial stability, and the overall effectiveness of interest rate decisions.

A Hidden Erosion Beneath the Surface

When central banks raise interest rates to fight inflation, the value of long-term bonds falls. Banks that built up large portfolios of low-yield securities during the era of zero and negative rates suddenly find themselves sitting on substantial paper losses. Though these losses are not immediately recorded in profit and loss statements, they silently erode banks’ economic capital. Schmidt and Fritz show that since 2022, these unrealized losses have surged sharply, particularly among smaller euro area banks with concentrated portfolios and limited interest rate hedging. The phenomenon has exposed a hidden erosion of balance sheet strength that traditional indicators fail to capture.

The Shadow Tightening Effect

The study’s core insight is that unrealized losses alter how banks behave long before any of them are formally recognized. Faced with depleted buffers and supervisory pressure, banks act defensively: they restrict new lending, tighten credit standards, and hoard liquidity to safeguard their stability. The authors call this behavioral change a form of “shadow tightening”, a silent contraction in financial conditions that amplifies the effects of rate hikes.

Yet, the reaction is not always straightforward. In extreme cases, when losses become large enough to threaten solvency, banks may gamble for recovery by taking on greater risk in search of returns. This dual dynamic, caution at first, followed by risk escalation, creates nonlinear feedback loops that can destabilize monetary transmission. It means policy rate increases might initially overperform, tightening conditions too quickly, only to later fuel instability and disorderly credit behavior.

Empirical Evidence from Euro Area Banks

Using a decade of euro area banking data from 2014 to 2023, the paper finds robust evidence that banks with larger unrealized losses cut their credit growth by as much as 2.5 percentage points more than peers with smaller valuation hits. Case studies of medium-sized institutions in Germany and Italy illustrate the dynamic vividly. As rates rose sharply in 2022–2023, these banks’ portfolios of long-dated sovereign and covered bonds suffered steep paper losses. Though their official capital ratios remained unchanged under accounting rules, their lending to households and small businesses fell noticeably. This “invisible constraint” on credit, the paper argues, represents an overlooked drag on monetary policy effectiveness at a time when the ECB seeks decisive disinflation.

Opacity and the Illusion of Strength

The persistence of these hidden weaknesses is closely tied to accounting conventions. Many banks classify large chunks of their securities as “held to maturity” (HTM), shielding them from mark-to-market revaluation. While this practice reduces short-term capital volatility, it conceals the true economic impact of rising yields. Schmidt and Fritz warn that this opacity prevents markets and regulators from grasping the real distribution of vulnerabilities. When confidence falters, these unseen losses can suddenly materialize, just as they did during the U.S. regional banking turmoil in early 2023, when unrealized losses triggered depositor flight. The authors caution that similar conditions exist in parts of Europe, even if they are less visible, and that this “illusion of strength” may be masking systemic fragility.

Rethinking Monetary Policy in a Post-Zero World

Beyond its empirical rigor, the report issues a broader warning for policymakers. Unrealized losses are not passive side effects; they actively shape how monetary policy transmits to the real economy. By eroding bank balance sheets, they mute the pass-through of rate hikes, distort credit allocation, and potentially force central banks into premature reversals to prevent instability. The researchers argue that monetary frameworks must better account for valuation effects, duration risk, and transparency gaps in the banking sector. They advocate clearer disclosure of unrealized losses, stronger duration management requirements, and supervisory practices that recognize how balance sheet stress can undermine policy credibility.

In the end, Schmidt and Fritz deliver a sobering message: the real fragility of the post-pandemic financial system may not lie in what appears on balance sheets, but in what remains hidden within them. The paper’s central lesson is that monetary tightening carries invisible costs, and ignoring them risks overestimating the power of interest rates while underestimating the vulnerability of the institutions that transmit them. As the authors put it, the path to price stability runs through the balance sheets of banks, and those balance sheets, weakened by unseen losses, may be less resilient than they look.