Mr. Hove, the acting chairman of the Federal Deposit Insurance Corp., warned recently that a sudden rise in interest rates could hurt a number of banks. Excerpts follow from his testimony before the Senate Banking Committee.
The steep yield curve produced by the much sharper drop in short-term rates than in long-term rates - coupled with the general move toward higher-quality assets - has led many banks to fund longer-term investment securities, such as Treasury bonds, with shorter-term deposits.
The number of banks holding concentrations in longer-term investment securities is increasing. As of June 30, over 1,200 banks had invested at least 20% of their assets in investment securities with maturities of five or more years.
In aggregate, these banks hold more than 9% of the industry's assets. A rise in rates generally would devalue these portfolios of debt securities. If short-term rates rose faster than long-term rates, net interest margins would be detrimentally affected.
In addition, banks have increased their off-balance-sheet activities and their investments in highly sophisticated derivative products, such as collateralized mortgage obligations, in recent years.
It is important that banks understand the risks of these instruments, as certain of the risks become more apparent during periods of changing interest rates.
We are also concerned about the impact of changing interest rates on the value of purchased and excess mortgage servicing rights, which represent a significant asset category for some banks and especially for thrifts.
Finally, a rise in rates could negatively impact the economic recovery, causing problems among bank borrowers.
The FDIC has been developing specialized expertise to more carefully monitor and supervise these activities and is working on regulations to incorporate interest rate risk in the risk-based capital standards.