In his annual report, Federal Reserve Board Chairman Ben Bernanke reassured Congress that the Fed intends to keep interest rates low. Nevertheless, many bank-debt investors and the general market remain nervous, and they are convinced that external events could still push rates up.

U.S. banks are mostly well positioned against such an event, and their margins could even widen from a rate spike. Nevertheless, some could find themselves absorbing another heavy blow to their asset quality.

There are several reasons to be concerned about the impact of a sudden rate rise on U.S. banks. When a bank's wholesale debt profile becomes skewed toward short-term maturities, for instance, it becomes quite vulnerable to such an event. Moreover, higher interest rates mean that it is more likely there will be delinquencies in the already-troubled books that hold variable-rate consumer and commercial real estate loans. Additionally, funding costs will go up, and such rates tend to hobble the bank's ability to offload nonperformers by selling them.

This situation highlights a major difference between the banking crisis of the early 1990s and the current one. In the later stages of the 1990s crisis, interest rates were high. Unlike today, however, the Fed then had the luxury of cutting rates, thus improving the banks' ability to sell off bad assets-which, in turn, helped to facilitate a recovery.

Some of the "what ifs" that could drive rates up were reviewed at a symposium the Federal Deposit Insurance Corp. hosted in January. The speakers, Donald Kohn, the Fed's vice chairman, and Laurence Meyer, a former member of the board, essentially backed Bernanke's position that an interest-rate spike was not likely any time soon, but they also identified other situations that could provoke a sudden rate rise. In addition to citing the collapse of the U.S. dollar as a possible instigator, Meyer said the market could develop an unfounded view on its own that inflation would soon become a problem. If such a perception gets enough traction, Meyer believes that the Fed would have to boost rates simply to protect its credibility as the ultimate defender against inflation-even if its imminent arrival was imaginary.

The speakers also pointed out that there is a very sizable inventory of financing that requires investors. When that need meets a scarcity of funding, rates will naturally be driven up. For instance, the U.S. government has to fund its sizable deficit and the banks themselves will have to roll over a cluster of debt maturities in the near future.

Over the last decade or so, banks took advantage of stable, low interest rates to raise large amounts of funds via debt issuance and securitization. More significantly, however, managements aggressively sought to take advantage of low rates to reduce their cost of funds in response to competitive pressures; the result was that they shortened their debt maturities, despite periods of relatively flat yield curves.

We estimate that the banks we rate worldwide will face maturing debt of about $10 trillion by the end of 2015, and $7 trillion of this will occur by the end of 2012. In the United States and the United Kingdom, banks will be challenged by more than $2 trillion of maturing debt by the end of 2012.

Most U.S. banks-95 percent-are not liability sensitive, so an unexpected spike in interest rates would not necessarily result in a squeeze on their net interest margins. Instead, their assets would re-price more quickly than their liabilities. Managements will keep their assets short to ride the benefit of rising rates, and they will want to keep their shorter-term securities reinvested in higher-yielding instruments.

However, timing will be everything. Not every bank will be perfectly positioned to handle the arrival of higher rates, but their managements may seek to extend their securities books to make some temporary gains anyway-and then get caught short. One consequence would be that they would wind up paying out more to stay in the game.

Any surprise interest-rate spike will demand close monitoring during the coming months.

Jones is a Senior Vice President, Moody's Investors Service.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.