Record profits and rising markets have led to some deserved optimism about the state of the banking industry. But concern is growing about an issue that has worried many for some time: interest rate risk. A long-simmering mix of high liquidity and low interest rates could spell trouble for many banks, consumers and businesses.
Regulators have said they consider interest rate spikes to be a risk with systemic implications. Federal Reserve Chairman Ben Bernanke told Congress that the dangers of rising rates are a major consideration in the Fed's withdrawal from the open market. Federal Deposit Insurance Corp. Chairman Martin Gruenberg, reporting the most lucrative quarter in the history of American banking, said that the risk of rate spikes made it "a fairly tricky environment for the industry."
Their concern is justified. The true danger to banks and their customers has been lurking in the market for some time: a low-rate trap. Interest rates have crawled up from their trough in summer 2012, but they remain deeply depressed by historical standards. Finding yield is tough for anyone in this environment. Even as bank profits have recovered, net interest income has not, with the industry average dropping 37% over the last five years.
Banks have two options when interest income wanes: Rely on noninterest income, or take on greater risk. Consumers don't leave much room for the first option, as they rebuild their nest eggs and rebel against fees. That makes the second option wandering out on the risk curve hard to resist.
Certain mechanisms already in the marketplace make this temptation stronger and more dangerous: long-dated commitments at low interest rates; fixed- or variable-rate loans with a cap, where even modest upward movements in prevailing rates would put a loan underwater; and bank securities portfolios with structured or unstructured products that can be equally sensitive.
The resulting dynamic poses dangers for businesses as well as banks. Assets and product lines that make sense when financed at 4% can make far less sense at 6%. This is especially true and especially painful in real estate, where low rates have already triggered a nascent housing boom in some regions. The value of an office building or a house in real terms can fall quickly in a time of rising rates, as can resale velocity and the pace of new construction.
Consumers may face the most pain from steep rate increases. Their longer-dated fixed income assets will, of course, drop in real value. But many consumers, pension funds and others have also made the same mistakes as some financial institutions, venturing into riskier investments than they would ordinarily be able to sustain. When rate hikes hit these investments, life savings and livelihoods are put at risk.
The ultimate problem is not that rates will rise. Given the depths they have recently plumbed, this is both unavoidable and, in some ways, desirable. It is the pace of rate increases, and the expectations surrounding them, that should be a source of concern. Bankers and consumers should heed Bernanke's warning and examine their exposures carefully, with realistic expectations of what may become the new normal in the post-crisis economy. If not, reaching that new normal could be quite painful.
Eugene A. Ludwig is a founder and the chief executive of Promontory Financial Group LLC. He was the comptroller of the currency in the Clinton administration.