Bankers cannot wait until the inevitable rise in interest rates before deciding how they plan to handle it. That's the consensus among regulators, who are increasingly concerned about institutions getting caught off guard as the unprecedented low rates start to normalize.
It's enough of a worry that the Federal Deposit Insurance Corp. had a day-long conference in late January devoted solely to interest rate risk management. The trouble is that some institutions holding on to long-term assets are relying too heavily on cheap short-term funding. "I'm afraid that the risks of this business model will become all too clear when interest rates rise, or the yield curve flattens," FDIC Chairman Sheila Bair said at the conference.
Fallout from sharply rising interest rates helped cause hundreds of thrift failures in the late '70s and '80s, as rates climbed to as high as 20 percent. At that time, thrifts primarily held long-term assets - 30-year, fixed-rate mortgages - which elevated risk because many were funded with short-term liabilities. Nobody is predicting the impact on the industry will be of the same magnitude this time around. But some institutions are likely to suffer nonetheless.
"You have losses occurring in the loan portfolio on the asset side. When you compound that with the rising-rate environment and compressing margins, that could create a situation where you're having even greater depression of earnings," says Charles Vice, commissioner for Kentucky's department of financial institutions. "Do we have a lot of banks that this could potentially cause to fail? No. Do we have a lot of banks that this would compress their earnings stream and make it more difficult to augment capital? Yes."
William Haraf, the banking commissioner in California, isn't sounding the alarms just yet. "If interest rates move sharply, the impact could be very substantial. But I want to emphasize that that is 'if' interest rates move sharply," he says. "It's just a generic concern."
Among federal banking agencies, the FDIC has been the most vocal in its concern. In a Dec. 17 Supervisory Insights publication, FDIC officials warn that some institutions, in the process of chasing earnings during the low-rate period, may have taken on substantially more risk. The report noted an increase in assets with extended maturities. Whereas such assets made up just 24 percent of the industry's total in 2006, that figure was near 40 percent in June 2009. Meanwhile, noncore funding, which the FDIC regards as less stable and vulnerable to interest rate changes, remains popular with institutions with longer-term assets. Smaller institutions are also increasing their use of long-term mortgages as they hold fewer construction and development loans. A joint agency advisory urges institutions to do stress tests to gauge their interest rate risk.
George French, the deputy director of policy in FDIC's division of supervision and consumer protection, says that while regulators are not predicting a "crisis situation," there are some institutions that "do appear to be getting a little more extended" on interest rate risk.
Kerri Corn, the director of market risk in the Office of the Comptroller of the Currency's credit and market risk division, called the agencies' joint advisory "a shot across the bow."
"We started off the guidance saying, 'We understand you take on interest rate risk. It's what you do. It's part of your business. Just do it wisely,'" says Corn. "Do we see it as a big issue right now? We do not."
Even Vice, the Kentucky commissioner, says he remains more worried about asset quality. "Most of our banks would be able to weather an impact to earnings with rates increasing a lot better than they've been able to absorb some of these asset-quality problems," he says.
Regulators are urging banks with disproportionate levels of short-term funding and long-term assets to recalibrate. "Banks, when they realize they have a mismatch, can replace investments that roll off through organic growth with shorter-term investments," says Kyle Hadley, the chief of examination support in the FDIC's division of supervision and consumer protection. "They could also try to extend their funding profile, issuing longer-term CDs or obtaining longer-term borrowings. If the bank is capable of certain reasonable interest rate risk hedging, we're not discouraging that if it is within their means."
But, he adds, "We don't want banks to recklessly go and adjust their balance sheet. We want it to be a managed process."