Interest rates will rise sooner or later, and banks should be prepared to manage their risk exposures, according to a report from the Federal Deposit Insurance Corp.
The historically low interest-rate environment since 2008 has prompted banks to rely more heavily on longer-term loans and securities, according to the report issued last week. But the value of longer-maturity securities may decline as interest rates increase, putting banks' earnings, liquidity and images in jeopardy.
"In the event depreciated securities have to be sold, unrealized losses become realized losses, reducing the institution's regulatory capital position," the report says. "Furthermore, unrealized losses on available-for-sale and held-to-maturity securities may also reduce equity capital under U.S. generally accepted counting principles."
To reduce risk, the report recommends that banks test their securities portfolios' exposure to rising rates, consider increasing their holdings of shorter-maturity or variable-rate securities and lock in profits by selling longer-term securities, among other suggestions.
The report also recommends that banks prepare for shifts in customer behavior as interest rates climb. Deposits have swelled at banks in the years since the recession, and the percentages of assets funded by deposits has risen to the highest levels in 15 years -- 63.2% for banks with more than $1 billion of assets, and 83.8% for those with less than $1 billion of assets.
That trend could change as customers return to rate-sensitive products like certificates of deposit in order to take advantage of higher interest rates or pursue alternative investments as their financial circumstances improve, the report suggests.
"Banks should create scenarios that take into consideration how funding mix and interest expense would change if deposit balances shift toward higher-rate products, or deposit balances leave the bank altogether and need to be replaced by alternative funding sources," the report says. "Banks that have experienced a significant increase in deposit balances or a shift in funding mix should consider the potential for reduced pricing power of their deposit products."