Watch out for the rate hike hit to banks

June 13, 2013 4:03 pm

Watch out for the rate hike hit to banks

By Gillian Tett

Regulators and bankers are assessing how damaging a US rate increase might be

Earlier this year, officials at America’s mighty Federal Deposit Insurance Corporation engaged in a bout of brainstorming with bank leaders about interest rate risk. The message was sobering.

Back then, in April, the FDIC did not seriously expect US rates to jump soon. Little wonder: at that stage, the 10-year yield was still below 2 per cent – and sinking – while Ben Bernanke, the US Federal Reserve chairman, seemed committed toquantitative easing.But if rates were to rise, the fallout could be painful, the regulator warned. Or as Dan Frye, an FDIC official, told the bankers: “If rates started going up today it could have serious consequences for some of our banks … a lot of banks would get hurt.” Indeed, the FDIC felt so uneasy about the issue that it begged banks to start scrutinising their balance sheets, in readiness for that day.

Investors – not to mention bankers – should take note. After all, a rate increase is no longer an entirely hypothetical idea. On the contrary, in the past couple of months 10-year Treasury yields have jumped 60 basis points, amid speculation that the Fed could embark on a “tapered” end to QE next year.

That increase has already inflicted painful losses on bond investors and some hedge funds. And though banks have remained out of the spotlight, as bond market volatility rises, the issue raised by the FDIC is now looking doubly pertinent; notably, what regulators and some bankers are trying to assess is just how damaging a rate increase might be – not just for big banks, but small ones too.

Opinions are mixed. In theory, a return to more normal levels of US interest rates in future years should be beneficial for many banks. After all, low rates typically cause banks’ net interest margins to shrivel. And in the past two years the margin squeeze has been so painful that some Fed officials say banks actually want QE to stop, as soon as possible. “In my district, the banks are saying that low interest rates are killing them – they want higher rates,” says one regional Fed president.

But there is a crucial catch. Precisely because of that margin collapse, many banks have quietly been adopting novel – if not desperate – strategies to boost earnings. Some have been extending more long-term loans, often at fixed rates, or investing in risky bonds or complex structured products. And that could potentially create big losses if rates rise, particularly if this swing occurs dramatically, as in 1994.

For the moment, at least, most regulators appear to think, or hope, that the largest US banks are fairly well protected against that risk. That is partly because large banks have rebuilt their capital reserves since 2008, but also because many have engaged in sophisticated hedging strategies.

However, one problem for investors is that banks’ balance sheets are so opaque that it is difficult for outsiders to judge the resilience of such hedging. And for the smaller banks there are other risks. Right now, according to FDIC research, just 3 per cent of community banks use sophisticated financial products to hedge interest rate risk; instead, they typically try to respond by managing their assets and liabilities sensibly. However, this task is becoming much harder. One reason is that banks have extended more long-term mortgage and commercial loans, often at low(ish) fixed rates. But another issue is a growing use of short-term debt and non-maturity deposits; in the past couple of years some $1,500bn has moved from money market funds to bank deposits, due to those low rates.

The net result of this, as the FDIC says, is that “the current structure of bank balance sheets suggests greater sensitivity to higher rates” than in 2004, or the last time that interest rates started rising sharply. Back in 2004, long-term assets were just 17 per cent of banks’ portfolios; now they are 28 per cent. Similarly, in 2004 non-maturity deposits were 48 per cent; now they stand at 59 per cent. However, if rates rise, money could flood out of those non-maturity assets, just as banks get hit by the costs of long-term, fixed loans. “Some banks are doing crazy things, to chase yield,” mutters the chairman of one small bank. Or as Mr Frye says: “There is still this tendency to seek short-term gains with long-term costs.”

Of course, for the moment, these risks and costs are merely hypothetical; the Fed insists that it wants to keep rates low for some time. And if it does that, then banks should have enough time to adjust. But, there again, the longer that the Fed staves off that day of monetary policy reckoning, the more that some banks may be tempted to keep chasing yield – and ignore those FDIC appeals. It is just one more reminder, if any were needed, of how fiendishly difficult it will be to “exit” from QE without triggering shocks; even with that infamous “taper”.