WASHINGTON — As speculation swirls about when the Federal Open Market Committee will raise prevailing interest rates, policymakers are beginning to worry about the impact on financial institutions, many of which could face new risks as a result.

The FOMC on Oct. 28 decided to keep the target federal funds rate between zero and 0.25% — the "zero bound" rate that the committee has had in place since December 2008.

But that unprecedented accommodative interest rate environment has spurred banks to offer long-term loans at very low rates of return, and if the cost of funds goes up — especially if it goes up more dramatically than expected — it could put depository institutions in a tough position.

"I spend a lot of time with regulators, and I can tell you that [their concerns are] interest rate, interest rate, interest rate and some more interest rate," said Mayra Rodríguez Valladares, managing principal at MRV Associates. "They are very concerned about whether banks can really cope with those changes … it's definitely a key thing."

Regulators have said as much themselves. Federal Deposit Insurance Corp. Chairman Martin Gruenberg in September said that the agency has seen banks — particularly smaller institutions — making up for low-yield loans with longer curves and higher volume, which raises the concern payouts on deposits won't be able to keep pace with revenues from these low-yielding portfolios. The FDIC is also poised to release updated data on the prevalence of interest rate risk nationwide in the coming weeks.

"We have been seeing banks going further out on the yield curve in order to generate revenue in a challenging interest rate environment," Gruenberg said. "If the interest rate environment changes, there are potential risks to institutions, and that has been a focus, if not the leading focus, of our supervisory activity."

The Financial Stability Board, the Basel-based global consortium of financial regulators and central banks, published a proposal in June suggesting that regulators might either set capital standards or supervisory standards to mitigate interest rate risk. The proposal, which was only supposed to apply to globally-active banks with more than $250 billion in assets, was roundly criticized by the industry as overly prescriptive and heavy-handed.

Interest rate risk is best understood as a situation where a bank's revenues from its assets are inadequate to keep up with its obligations to its depositors. The savings and loan debacle of the 1980s is probably the most popular example of a financial crash brought on by interest rate risk, where dozens of thrifts promised double-digit interest rates backed by the then-equally high federal funds rate. When the Fed lowered rates, the small banks lacked any matching loan base to cover those obligations and went under by the thousands.

Those circumstances differ dramatically from what banks are facing today. Many of the larger banks do not rely on deposits as heavily as smaller banks do, nor do they necessarily rely on loans as a majority of their revenue streams. But there is a diversity of opinion on whether it is larger banks or the smaller banks that might be stressed when rates rise.

One factor that is uncertain is what will happen to deposits when rates go up. Karen Shaw Petrou, managing partner at Federal Financial Analytics, said that banks have traditionally been insulated from fluctuations in the federal funds rate because people are less likely to move all their money around chasing after a modestly higher return. But that "sticky" nature of deposits may have eroded since the Fed last raised its rates, she said, because there are so many more places to put one's money, especially if firms don't have to work as hard to achieve more attractive returns.

"Historically, deposits have been sticky because they have no place — other than mutual funds and money market funds — to go," Petrou said. "We know that is not going to be the case now, though there is a lot of debate about what is going to be the case."

Michael Driscoll, senior vice president and head of rating agency DBRS' U.S. Financial Institutions Group, said the expectation throughout the industry is that the historically high level of bank deposits since the crisis will start to migrate toward higher yields elsewhere. That could put a pinch on some banks, but probably not the smaller banks for which deposits are still a primary source of funding. But nobody knows what will happen for sure.

"I think the biggest wild card … is what's going to happen to deposits," Driscoll said. "Basically, the industry is awash in deposits, a lot of on-a-string deposits. The big million-dollar question is how do you model that runoff when rates start rising."

And that stickiness of the traditional small banking model — and, by contrast, the sophistication of clients of the larger banks — is what could make larger banks more susceptible to a cash crunch if interest rates were to swing upwards unexpectedly.

Chris Whalen, senior managing director of the rating agency KBRA, said that in many of the larger banks, assets in a portfolio are turning over at a much faster rate — they're available for sale, and they are priced regularly. If an asset's returns are no longer competitive or attractive, they have to be re-priced, and that can hurt and can take time, he said.

"It takes a while to reprice assets," Whalen said. "The notion that big banks are going to benefit in the short run from higher rates I think is suspect in that regard because half of their funding book is facing the market — it gets repriced every day."

Also at issue are bank clients. Many small business or commercial and industrial loans are based on floating rates of return, and so if the Fed raises rates substantially over time, those clients would have to pay more for the same loan. Valladares said the timing for such an increase could be problematic, since many industries — particularly energy, commodity and export-reliant firms — are facing particularly hostile economic conditions, and with falling revenues and higher interest on debt, it could spur some companies to default.

"So we're going to raise rates, and … those companies are going to face lower revenues and higher cost of funding," Valladares said. "We're in a very precarious situation, because the economy is so slow, and now you're going to raise rates, and you're going to push companies into … being a credit risk."

There is a secondary effect to those potential defaults as well. Even if a bank's balance sheet is relatively healthy, most of those floating-rate small-business loans and C&I loans are guaranteed by swaps, particularly for regional or medium-sized banks or larger. If a bank's client defaults, the bank still has their end of that swap and will have to unwind it, which can be costly.

"You could have this really horrible effect where [a borrower] is starting to pay late on a loan, and then [they] default, and then these guys are stuck trying to unwind all these interest rate swaps," Valladares said. "The worst problem is that you've defaulted on me, and I still have this outstanding swap … and then I turn around to a big bank and try to unwind, and that's going to cost me money."

It is also not necessarily true that the Fed has nowhere to go but up when it comes to interest rates. The purpose of lowering the federal funds rate is to stimulate growth — to heat up the economy. The converse is also true — raising rates is a countercyclical measure to keep inflation from running out of control. But in the current environment, growth has not been so hot — particularly in commodity and export sectors — as to make a tighter fiscal policy an obvious move.

The European Central Bank last year decided to move its interest rate on excess reserves into negative territory, effectively charging for deposits. Several other European central banks followed suit. For the first time, an unspecified U.S. Fed governor proposed a target rate of -0.25% during the September FOMC meeting. More recently, Fed Chair Janet Yellen told the House Financial Services Committee Wednesday that she could not rule out a negative interest rate, though she thought it was highly unlikely.

Most observers agree that the prospect of negative rates is exceedingly small. But Petrou said that the possibility is not as remote as some people think, and if negative rates were to come to pass, the results could be profound and unpredictable.

"If rates go negative, it's a really huge problem … and I would not discount that," Petrou said. "Their accommodative policies are not working as they want, and they can't just keep buying assets."

The most likely scenario, according to Ernie Patrikis, a partner with White and Case and former vice president of the New York Fed, is that the Fed gradually raises rates in such a way that banks can adjust gradually to the FOMC's long-term target rate of around 3.5-4%. But the kinds of interest rate risk that could be truly damaging is if inflation begins to take off rapidly and unexpectedly, spurring the Fed to raise rates faster than it would prefer.

In that case, there could be some exposures for the larger banks engaged in securities and in the bond market. But as a general matter, Patrikis said, smaller banks tend to bear the brunt of unexpected changes and are not as well equipped to respond to them.

"The Fed's [move] will bite slowly, unless inflation really starts to take off and the Fed has to move aggressively," Patrikis said. "I don't see any immediate impact. It will be gradual, and then to what extent rates keep going up, it will first bite on the smaller banks."

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.