Stealing a move from Punxsutawney Phil, the Federal Open Market Committee peeked out at the world last month and declared two more years of low interest rates.
It was an interesting wrinkle for banks that had been dangerously stepping up the duration in their securities portfolios to juice returns—a behavior that had not gone unnoticed by bank regulators.
Certainly when the policy-setting committee of the Federal Reserve forecasts the long continuation of a low-rate environment, the act of taking on additional interest-rate risk suddenly looks a lot less threatening. But banks that look at the FOMC's stance and feel emboldened to take on more interest-rate exposure than they already have may wind up with a Groundhog's Day experience of their own, finding their regulators once again sniffing around their securities portfolios for signs of trouble.
"The danger is that in the interest of trying to preserve their spread, people go further out" the yield curve, longtime independent bank consultant Bert Ely says, "and when rates go back up, they get clobbered."
The lawyer and economist Robert Litan says experience has taught the industry how to prepare for changes to the interest-rate environment. "By and large, banks are a lot more nimble and less interest-rate sensitive than in the old days," says Litan, who was on the staff of the President's Council of Economic Advisers in the Carter administration and is now affiliated with the Kauffman Foundation and the Brookings Institution.
But in a static, low-rate environment, there is not much banks can do about the weakening value of noninterest-bearing deposits and the conundrum of where to reinvest cash when their securities investments mature.
"In general, a low interest-rate environment with a weak economy isn't good for banks, unless they can make up for it with fee income," Litan says. Slim chance of that, given the impact of new consumer finance regulations and the effect that all this economic sluggishness has had on loan demand.
Despite the more troubling signals coming from the economy, most bankers had expected, right up until the FOMC's statement, that the Fed's next big move regarding rates would be to increase them. Many banks had incorporated at least some bias toward that possibility into the management of their balance sheets, with investments that would benefit when the Fed finally started reversing the rate cuts implemented during the financial crisis. And bankers were ready for that day to come.
On a July conference call to review KeyCorp's second quarter, Chief Financial Officer Jeffrey Weeden told analysts, "We certainly need an increase in short-term rates, as well as on out to probably three to five years on the yield curve, which as we all know has been very much depressed."
Of course, it goes against conventional wisdom that banks would prefer a rising-rate environment. The rule of thumb says that the industry does best when rates are falling, because the cost of deposits generally drops faster than the yield on loans. But when yields get so low that bankers would need to price deposits below zero to earn much of a spread at all, it rewrites the whole equation for how rising rates affect banks.
"Interest rates going from zero to 3 percent is very different than going from 9 percent to 12 percent," says Fred Cannon, the director of research at Keefe, Bruyette & Woods.
For now, it looks like that theory won't get tested for quite some time. But the FOMC left itself some wiggle room to commence with rate increases before mid-2013 if it sees the need, and there are three committee members—from the Federal Reserve banks of Dallas, Minneapolis and Philadelphia—who dissented from the decision to put a time stamp on the rate forecast. Presumably they would urge a revisiting of the language if the economy, or inflation, starts to perk up.
"The Fed is is making a prediction" about keeping rates low, Ely says, "not providing a guarantee."
That's one of the dangers for banks that heap more risk onto their balance sheets. For other banks, a reversal in the Fed's stance generally would be a good thing—if it is prompted by a strengthening economy. But if rates ascend due to inflation without economic growth-stagflation—or because investors get nervous enough about the U.S. situation to flee Treasuries, then that's bad for everyone.
