A continued rise in interest rates could spell trouble for community banks and thrifts, the Federal Deposit Insurance Corp. said in a report released Tuesday.
Though many small banks posted record earnings in the first quarter, the FDIC said that more interest rate hikes, combined with the steady increase in cost of funds, could squeeze net interest income in coming quarters. The agency concluded that earnings at institutions with less than $1 billion of assets - which rely far more on interest income than their larger counterparts - are "more vulnerable" to rising interest rates than at any time in the past five years.
"The trends noted in our report underscore the importance of bank preparations for the possibility of continued interest rate increases and a less favorable economic climate," said FDIC Chairman Donna Tanoue.
The FDIC released its report on the same day that the Federal Open Market Committee raised the federal funds rate to its highest level since 1991. In an attempt to slow economic growth, the committee voted to raise the benchmark rate by 50 basis points, to 6.5%. Tuesday's hike was the sixth in the federal funds rate - which banks charge each other for overnight borrowing - since last June.
In its 10-page report, the FDIC said that institutions with less than $1 billion of assets generate 74% of their revenue from interest income. Larger banks, by contrast, make less than 60% of their revenue on loans.
The agency also cited two main causes of the rise in interest rate sensitivity at small banks and thrifts.
First, it said, long-term assets, as a percentage of total assets, have grown sharply in the last two years. Because interest rates had been low in recent years, many homebuyers opted for 30-year, fixed-rate mortgages, and homeowners refinanced, extending 15-year loans to 30. The result: "The percentage of mortgages that have a maturity or repricing frequency of less than one year has declined at commercial banks in favor of mortgage-related assets that mature or reprice in 15 years," the study said.
Second, dwindling deposits have forced many small banks to rely on more "volatile" funding sources to keep pace with loan demand, according to the FDIC. With loan-to-deposit ratios in the 90% range - a record - many banks and thrifts have no choice but to buy funds from the Federal Home Loan Bank System and other sources.
