With rates coming down after a year of increases, anxiety over interest rate risk is increasing among community bankers.
The recent downward pressure in interest rates is just the latest nail in the coffin of several good years during which banks, and small banks in particular, benefited from the steep yield curve and hefty bets on rising interest rates.
Community banks were the biggest benefactors of the hugely positive yield curve, funding their higher-yielding long-term assets with cheaper short-term deposits. But, as market rates shrink and pressure to lower the prime rate builds, balance sheet managers are getting more conservative.
The volatility of rates - on top of new accounting standards and the dark specter of derivatives - is sinking in, forcing bankers to accept less risk.
"You have to keep it conservative or you get your face taken off and handed to you," said Kenneth R. Brown, executive vice president of Liberty Bancorp, Oklahoma City.
"We're pretty well evenly matched. But we have really been forced to be," he continued. "Let's face it, there are times when one of the ways to make money in this business is a modest mismatch: You take a little interest rate risk. But with the accelerator-brake volatility we've had in the last two years, the risks are so great and you really don't get rewarded for taking them."
Mr. Brown, who helps set asset-liability policy at Liberty, a $2.7 billion holding company with banks in Oklahoma City and Tulsa, said he'd like to see a little more cruise control when it comes to interest rates - but he doesn't think that will be the case any time soon.
Bill McGuire, an industry consultant and expert on interest rate risk issues, said community banks are still seeing the lagging upward pressure on their deposit rates - more so than at larger banks whose deposit rates kept better pace with the market.
"So, with long-term rates coming down, we could really see some short- term squeezing at some smaller institutions," said Mr. McGuire, a former Sendero Corp. executive who advises banks on portfolio risk management.
He added that the downward pressure on interest rates highlights the modern reality at community banks, no matter how small: Rate volatility and FASB 115 - the 1994 accounting rule that forces bankers to classify securities portfolios and take hits to equity and earnings if they don't hold securities to maturity - require constant vigilance and the willingness to change direction quickly.
"There's so much that can reprice at any given time and over any duration that the typical community bank reinvents itself every 18 months," Mr. McGuire said.
If the prime were to drop, community bankers would have to face up to the fact that the yield curve, not their acumen at investing, was the primary reason for fat bank profits in recent years, said Jim Marks, an industry analyst at Hancock Institutional Equity Services in San Francisco. Some observers think the Fed could cut the prime later this summer in response to sluggish economic factors.
"A bank in '92, '93, and even in '94 was getting fat by bringing in short-term money and lending it out long term," he said. "That benefit is going to disappear."
Mr. Marks doesn't see it as a threat to the equity base - the way FASB 115 can be - but said it will affect return on average assets and to a lesser extent return on equity as the yield curve flattens and reserves come down from their current historically high levels.
But the benefit Mr. Marks sees is that community banks will ween themselves of interest rate driven profits.
"I can't hazard a guess on where interest rates are going, so I don't want a bank or thrift manager to, either," he said.
"What the lower long-term rates will do is eliminate the incentives to take that added risk," Mr. Marks said. "They were lucky - in this interest rate cycle, that risk didn't hurt anybody that much. But the risk is still there, even if it wasn't fully realized."
