WASHINGTON — The risks from rising interest rates — including the pain already being felt by banks in their debt-securities portfolios — are now on a collision course with the Basel III rules that take effect next year.

An uptick in interest rates, which regulators have warned banks about for some time, translated into a huge drop during the second quarter in the value of banks' available-for-sale securities, and such values could continue to decline if rates rise further.

But the largest banks, which must adopt a more complex version of Basel III known as the "advanced approaches" by Jan. 1, face a double whammy. Lower securities values would hurt their capital levels as measured under the new rules.

Banks have several options for easing the blow, including redirecting securities to areas of the balance sheet not subject to the accounting change.

Basel III has "effectively … brought interest rate risk into the capital calculation for large banks," said Hugh Carney, a senior counsel for the American Bankers Association. "That's a problem, and banks are struggling with how to manage it."

The Federal Deposit Insurance Corp. recently reported that, from March 31 to June 30, the industry saw a $51 billion decline in unrealized gains from the securities banks classify as sellable in the open market. It was the largest quarterly drop in the nearly 20 years the FDIC has kept such data.

Rising rates are believed to be driving investors to securities with higher returns than those held by banks. The yield on the 10-year Treasury bond, for example, rose from a low of 1.60% in early May to 2.48% by the end of the second quarter. With interest rates still historically low, more volatility is expected. Regulators have advised institutions that interest rates can swing as much as 400 basis points in volatile periods.

FDIC Chairman Martin Gruenberg highlighted the sharp drop in unrealized gains when his agency released the Quarterly Banking Profile in August, and he warned about it again in a speech Sept. 23.

Interest rate risk "will continue to be a focus of attention in FDIC safety-and-soundness examinations, as well as guidance we provide to insured institutions," Gruenberg said at the American Banker Regulatory Symposium.

But the coming Basel change, which will affect the 18 large banking companies subject to the "advanced approaches," has sounded a louder alarm.

Unrealized gains and losses in available-for-sale securities are already reported in capital calculations under "Generally Accepted Accounting Principles." But if the securities keep declining in value, those losses would be deducted from banks' regulatory capital measures starting in January.

"Interest rate risk in the available-for-sale portfolios is one of the big focus points for the [Office of the Comptroller of the Currency] right now," said Gerard Cassidy, an analyst with RBC Capital Markets.

U.S. regulators' original proposal for implementing Basel III would have forced all banks to count their unrealized gains and losses from available-for-sale securities toward their regulatory capital. But after protests from community banks and their supporters, the final rules unveiled in July applied the change only to the largest companies subject to the "advanced approaches." Smaller institutions can still opt in to that requirement if they choose.

Large banks have essentially three choices for limiting the damage, observers said.

One option is to shorten the durations of available-for-sale securities on their investment book that pay lower yields.

"If you have shorter-maturity assets, a rise in the interest rates does not give you as much unrealized losses. … It's a matter of degrees," Carney said. "If it's a short-term asset, you're getting that lower return for a shorter period of time."

Alternatively, he said, banks could reclassify certain securities as "held-to-maturity." Such assets would have to be held longer and are more difficult to sell in a liquidity crunch, but "unrealized gains and losses do not flow through on held-to-maturity assets" in the bank's capital reporting.

But Carney and others said steps to reapportion assets have their own risks, since banks still want to have an ample supply of available-for-sale securities that they can sell easily in an emergency.

Luigi De Ghenghi, a partner at Davis Polk, said available-for-sale securities provide banks with a tool for complying with other provisions of the Basel rules calling on banks to strengthen liquidity.

"I don't think anyone will be unloading tons of AFS debt securities," he said. "They still provide institutions with liquidity and collateral, and the new Basel liquidity requirements are going to require banks to hold more high-quality liquid assets, and those include AFS debt securities."

A third option, observers said, is simply to hold higher capital than even the Basel rules require to make up for potential losses in a bank's available-for-sale portfolio resulting from sharp rate fluctuations. The international rules require a 7% Tier 1 common capital ratio for all banks, with an additional buffer for the largest "systemically important financial institutions."

"On top of that, I think the banks are going to want to carry some additional capital to play it safe to protect themselves from an unexpected rate rise," Cassidy said.

Carney agreed, saying that "particularly in this rate environment — after rates have been low for awhile — banks are looking at potentially some substantial unrealized losses as the rates go up.

"They're going to have to manage that," Carney said. "Instead of holding 1% or 2% above the minimum regulatory requirements, they're going to need to hold 2% or 3% in order to absorb those unrealized losses and any potential volatility thereafter."

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