Rising rates: Interest rate risk focus for US banks
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Rising rates: Interest rate risk focus for US banks

Fed stress tests likely to make risk public; warnings of impact on securities portfolios.

The deadline for US banks to submit their own stress tests to the Federal Reserve falls this month. It is the first time that US banks have been asked to test their models against their own chosen risk scenarios. The results will be published in the second half of September.

The banks are likely to focus on two points, says Jason Goldberg, bank analyst at Barclays: capital rules and interest rate rises.

Concern around interest rate rises has been building up, but until recently the banks have remained quiet about associated risk. The US banks’ stress test earlier in the year did include testing on a rise in interest rates, but the Federal Reserve did not make the data public.

Although the Fed might not raise short-term interest rates in the next two years, at the long end yields have risen following speculation that the Fed might start to reduce bond buying in September. At one point in June, benchmark 10-year yields hit 2.66% – the highest since August 2011. Thirty-year yields rose to 3.65% – the highest since September 2011.

Fixed-income investors are nervous of an abrupt tapering by the Fed and have been pulling out of bond funds. Outflows from bond mutual funds and ETFs in June totalled some $60 billion, beating the outflows of October 2008 at the peak of the financial crisis.

Positives and negatives

Rising interest rates produce positive and negative results for banks. On the one hand, banks can charge higher rates for loans and net interest income rises as yields on longer-run assets increase faster than those on banks’ short-term liabilities. The chief executive of one bank with a large wealth management business boasts to Euromoney that a 300 basis point rise in rates would add $3 billion to his bank’s revenues.

However, defaults will increase. Also, unless coupled with economic growth, higher rates tend to deter lending, thus eating into profits. Bank of America analysts said in a June report that rising interest rates will reduce the sales of commercial-mortgage bonds by half during the last six months of 2013.

JPMorgan Chase CEO Jamie Dimon
JPMorgan Chase CEO Jamie Dimon

Higher long-term interest rates can cause losses in banks’ securities portfolios that will have to be marked down. CEOs at the largest US banks are beginning to highlight the impact. In his annual letter to shareholders, JPMorgan Chase CEO Jamie Dimon, wrote: "We need to be prepared for rapidly rising rates, potentially even worse than we have seen in recent history." And at an investor conference in June, Bank of America CFO Bruce Thompson reportedly said that the bank might lose as much as $11 billion in its bond and loan portfolio if interest rates were to rise 1%. He said that was as much as three times what the bank would gain from higher rates in its lending business. "Some banks have done a better job at positioning themselves for potential higher rates than others," says Goldberg. "It means giving up earnings in order to be prepared though." The biggest implications, he says, will be in unrealized gains, which were $30 billion at the start of the second quarter and will be much lower because of the jump in treasury yields.

Fitch Ratings echoed the warning in a report in the middle of June in which it said: "Unrealized gains on securities held on US bank balance sheets have risen to historically high levels, potentially setting the stage for a reversal of gains and an ensuing erosion of capital levels should rate increases hit bond prices hard. This is especially relevant given banks’ increased exposure to mortgage bonds in investment portfolios on both an absolute and proportional basis."

No pressure

The chief executive of one US bank, sounding rather nervous in late June, reassures Euromoney: "Substantially reduced supply supports the bond markets. We may see a net shrinkage of the agency mortgage market as paydowns exceed new originations. I don’t feel a lot of pressure building up in the rates markets." Banks are still trying to convince themselves that if the Fed were to exit its bond-buying strategy gradually, there might be little to worry about.

"However", says Fitch "to the extent that this does not occur, we see the potential for further declines in bond prices, with losses potentially larger on a percentage basis than those reported during the credit crisis."

American credit unions might also be at risk if rates were to rise as a result of taking on interest rate risk through fixed-rate lending funded by variable-rate deposits.

Fitch analysts say that the rising interest rates might lead to M&A activity. "Rising rates may put additional pressure on banks with longer-duration balance sheets to pursue mergers with shorter-duration banks that will be better positioned to maintain earnings in a rising rate scenario," says their June report, US Banks: Interest Rate Risk – What Happens When Rates Rise.

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