As is well known, the Fed is trying to raise short-term interest rates sufficiently to persuade bond traders that inflationary pressures will be contained, thereby causing them to bid down long-term rates to more modest levels. If the central bank succeeds, the yield curve will have begun its long-awaited flattening. Yield curves generally flatten most when the markets judge that the central bank is acting vigorously to forestall inflation.
But while such a development is good for the overall economy, it is not necessarily good for banks. In fact, for many banks, a yield-curve flattening could prove quite troublesome. First, a lot of banks remain liability sensitive, so a rise in short rates will hurt them. Second, even those that are not liability sensitive will suffer for a reason that is almost always overlooked.
To understand this reason, let's briefly review some pertinent asset-liability facts. In the last few years, banks have acquired a great many assets of intermediate-term maturity (three to five years) e.g., collateralized mortgage obligations, asset-backed securities, and amortizing swaps. That's because the pronounced upward slope of the yield curve favored this kind of investment duration.
The typical yield curve of the last few years showed a pattern of rates rising sharply as the term to maturity lengthened, up to about the three-to-five-year point, after which the rate of rise. moderated appreciably. That being the case, it seemed to make sense to invest at a three-to-five-year maturity since further asset lengthening invited more risk without commensurately larger returns.
The way such intermediateterm assets were funded was also, in a manner of speaking, dictated by the yield-curve shape. Banks could have attempted to virtually match-fund by acquiring, say, four-year liabilities, either in the cash or, more likely, in the derivatives markets.
But, given the steepness of the yield curve, a combination of very inexpensive short liabilities and long ones - e.g., core deposits - produced an equivalent duration match at an appreciably lower interest cost. Thus, in an effort to extract more spread than would have been possible with simple intermediate-term funding, many banks proceeded' to "barbell" their funding mix.
Unfortunately, the above asset-liability configuration, satisfactory when the curve slopes sharply upward and all rates increase in a parallel fashion, becomes much less than satisfactory when the curve flattens in the way that the Fed desires. This kind of flattening will hammer banks on both the short and long ends of their liability structures.
Obviously, rising rates increase the cost of rolling the short liabilities. Somewhat less obviously, falling long rates also hurt banks because they are short a set of fixed-rate claims whose discounted present value is increasing (as the discount rate falls). So the total return on bank liabilities will rise.
That wouldn't be so bad if the total return on bank assets moved up in lock step. But despite the approximate match-funding of the asset portfolio, which should guarantee equivalent movement in asset values for a given change in liability ones, this won't occur. Historically, as the curve has flattened, its pivot point, or fulcrum, the point on the curve that is least likely to change, has had a threeto-five-year maturity.
Thus, the value of the intermediate-term assets probably will neither decrease nor increase materially. Otherwise put, although the claims of others on banks will be increasing in worth, those of banks on others will not be, which spells trouble for bank equity valuations.
How much trouble? Based on our consulting experience, we judge that the magnitude of bank exposure to this kind of yield curve "twist" is about as great as is the exposure to changes in the general level of rates. Yet, while many banks are active in hedging their core rate risks, few have even calculated their "twist" exposure, much less investigated the methods of neutralizing it.
In consequence, the effect of the events set in train by the Fed's attempt to tighten could be reduced bank net income and reduced valuations, as reported under FAS 107 and 115.
Can banks protect themselves from this threat? The short answer is yes ' by reordering the assets and liabilities to achieve a better cash-flow match or through a creative combination of interest rate swaps and futures contracts. But such a hedging strategy is by no means costless.
Whether it is worth executing depends on how much the yield curve flattens and for how iong. The flatter it gets and the longer it stays that way, the greater the damage and thus the more worthwhile and necessary is the hedging expenditure.
Mr. Toevs is a managing vice president of First Manhattan Consulting Group in New York.
