Fed Rate Hike Seen As Test Of Banks' Hedge Strategies

Because Federal Reserve policymakers are expected to raise interest rates again on Wednesday, more trouble may be in store for banks that are already suffering from pinched profit margins on loans.

Though the industry has been touted as less interest-rate-sensitive than in the past, a look at how banks have been managing their interest risk shows them to be in a poor position to protect earnings as the Fed's Open Markets Committee moves to stave off inflation by pushing rates higher.

Most observers predict at least a 25-basis-point hike. But some see a series of moves ahead that could jack up the federal funds rate by as much as 75 basis points, to 6.25%. That would make it much harder for poorly hedged banks to meet their earnings targets for this year.

For the past several years financial companies have been able to expand lending in a robust market. But as consumers put their savings in the stock market, deposit growth has lagged, forcing many banks to rely on more expensive short-term funds.

That is fine when interest rates are stable or falling. But banks, under pressure to sustain earnings growth, are now paying the price of their exposure. Rather than bear the cost to protect themselves from rising rates with derivatives, they chose the short-term goal of boosting profits.

"Banks and some thrifts have gotten more comfortable than they should be with un-hedged balance sheets," said John Kanas, chairman and chief executive officer of North Fork Bancorp. "There is great pressure on banks and thrift managers to make money. And they way to make money was to fund longer-term assets with short-term deposits. The less hedging you did, the wider the profit margins."

National City Corp., U.S. Bancorp, and Marshall & Ilsley Corp all are recent victims that had to approach Wall Street with the news they would not make consensus earnings estimates because of interest rate margin shortfalls.

Because more interest rate hikes are likely, mid-sized banks may be more vulnerable than more diversified big banks, said Rosalind Looby, an analyst at Donaldson, Lufkin & Jenrette Securities Corp.

"The more the Fed raises, the more they will feel the pain," Ms. Looby said. "The differentiating factor for those banks feeling the pain is the level of reliance on wholesale funding."

Banks such as First Merit Bancorp., Regions Financial Corp., Southtrust Corp., and National Commerce are all vulnerable, Ms. Looby said. All but National Commerce reported narrower interest rate margins in the fourth quarter than at the end of the third quarter. National Commerce actually had an increase to 4.21%, from 4.07%, due to a fourth-quarter hedge position. That position won't apply in the first quarter, and Ms. Looby predicts National Commerce's margin to drop to 3.85%.

Banks have increased their reliance on wholesale funding to 35% of sources, from 20% five years ago, said Michael Mayo, an analyst with Credit Suisse First Boston.

"Banks have taken their eyes off of the ball in generating core deposits," Mr. Mayo said.

Milwaukee-based Firstar Corp. is one of a handful of banks that have bucked the trend with a fervent focus on keeping the growth of deposits in step with loans. The Milwaukee bank's net interest margin increased in the fourth quarter to 4.17%, from 4.04% in the previous quarter.

"Our general strategy with regard to managing interest rate risk is to be as neutral as possible," said David M. Moffett, chief financial officer at Firstar. "We rely on the retail system to do our funding for us and make us less exposed to rate" changes.

Banks with balance sheet exposure such as National Commerce can reduce their risk to interest rate fluctuations, using derivatives such as interest rate swaps, floors, and caps. But doing so has its pitfalls. If a bank were to hedge all of its risk, it would miss the chance to make money, many say.

"It often makes sense to leave some interest rate exposure on the balance sheet, because you have a view on interest rates or the costs of eliminating the risk are too great," said James M. Coons at Huntington Bancshares in Columbus, Ohio.

But many banks may have found short-term profits too tempting, said Michael Plodwick, an analyst with Lehman Brothers in New York. "Revenue growth is tough to come by," Mr. Plodwick said, "and if you can goose your margins, you are going to do it."

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