Credit and capital have determined which banks will survive the financial crisis, but interest rate management may well decide which banks thrive as the economy recovers. As the focus shifts to earnings, though, a Federal Reserve exit strategy of epic proportions looms, and banks need patience to manage through this uncertain period successfully.
The challenge is the enormous temptation for banks to invest excess cash in longer-term securities. Deposit growth is exceptionally strong, but loan demand is very weak, so banks have lots of excess cash that earns next to nothing at today's rates. According to the Federal Deposit Insurance Corp., during the second half of last year loans fell by $340 billion while deposits increased $205 billion, creating more than half a trillion dollars of excess liquidity. In addition, earnings remain under pressure due to credit issues, so banks might want to offset that, at least in the short run, by investing in high-yielding securities.
The problem is short-term earnings gains can mean longer-term earnings pain. Though the Fed has interest rates on hold, there is only one direction the rates can go from zero. Thus, investing in longer-dated securities may generate earnings in 2010, but it is likely to sacrifice earnings in 2011 and beyond. The result could be many traditionally asset-sensitive banks, which gain earnings from rising rates, acting like liability-sensitive thrifts, losing earnings from rising rates. This is primarily because the funding costs for those securities will rise, reducing returns. Moreover, the duration on many securities will extend in a rising-rate environment, meaning that 4.5 percent mortgage-backed securities with a three-year duration today could stay around for four or five years as rates rise.
The Fed warned banks in January about taking on excessive interest-rate risk, and the wording it used is especially important. Combined with its statement that rates will remain low for an "extended period," the warning suggests that the Fed recognizes banks will continue to be tempted for most of this year to use excess cash to fund longer-term securities. The Fed specifically mentioned the risk such assets pose to capital, and this indicates a likelihood that unrealized losses and gains on securities will affect regulatory capital ratios in the future. Currently these unrealized losses and gains are excluded from regulatory ratios. However, the Basel Committee report on capital proposes that valuation changes on securities be included in regulatory capital. The Fed's statement could be an indication that U.S. regulators may go along with this proposal.
Thus, prudence suggests resisting temptation and maintaining liquidity. Besides avoiding the risks associated with an aggressive investment strategy, patient banks will benefit from future margin improvements anyway. Today's exceptionally low interest rates result in the most valuable business that banks have-generating core deposits-being almost worthless. When rates rise, those core deposits will again be valuable. Also, when loan demand returns, spreads should be good. During much of the 1990s and the early 2000s net interest margins at banks were pressured by the securitization market. With that market largely sidelined, banks can get more loans and better spreads than were available in the last 20 years. On average, net interest margins at banks were 40 basis points higher between 1978 and 1992 than post-1992, when the securitization market took off.
Nevertheless, it seems simpleminded for banks to sit on excess cash waiting out an "extended period" for the Fed to move on rates. Here are three actions banks can-and should-take today to ensure stronger margins in the future.
Lock up core deposits: Deposits have flooded into the banking system due to Fed monetary expansion, cash exiting the stock market and record-low interest rates. When rates rise, deposits will flow out. Banks that do the best job of retaining deposits will perform best in the future.
Invest conservatively and nimbly: A prudent strategy to invest in short-duration securities can add to near-term earnings with limited risk.
Focus on variable-rate loans: Loan demand remains weak, and the borrowers who are in the market want to lock in current low interest rates. However, variable-rate loans will be the most valuable in the future.
Overall, patient and prudent management of bank balance sheets should position survivors of the financial crisis well for a profitable future.