We recently discussed how overall loan contraction has resulted in banks growing their cash and government security holdings. Another prominent but overlooked issue facing the banking segment is interest rate risk, and the ramifications of how Banks are planning for it.
One needs to look no further than the S&L crisis to view the perils of unmanaged asset/liability gaps. Despite being extremely profitable at the time, these institutions failed to manage the risk of funding long-term fixed rate assets with short-term deposits.
Similarly, banks are faced with difficult decisions today as long term assets offer anemic yields, and an abundance of cheap funding abounds (brokered deposits etc..). There are no shortage of banks afraid to be stuck with a long term fixed rate asset (let’s say a 10yr treasury at 3%) with the fear of overnight funding rising dramatically.
This risk has not escaped the FDIC as Sheila Bair said “I do worry that credit quality …needs to be fixed, but the next issue is likely to be interest rate risk”. One banking analyst noted that “Banks have purposely given up current earnings for the ability to not lose money when rates rise”.
This analyst is referring to the potential mark-to-market risk in the event of a rapid rate rise. What has this forced banks to do?
- Become asset-sensitive: This means that in a period of rising interest rates bank assets will reprice faster than their liabilities causing an increase in net interest income.
- Short Assets: In an attempt to not be caught, many banking institutions have purchased/originated short low duration assets with minimal mark to market risk.
- Basel III Concerns: Although less likely, among the proposals floated would have unrealized losses deducted from regulatory capital. For obvious reasons, this would be very punitive.
- Liquidity Planning: Still somewhat spooked by the events of the credit crisis, institutions are purposely holding stronger and less vulnerable sources of liquidity.
- Reinvestment Risk: Maturing assets are being reinvested or rolled over into lower yields. Fixed rate loans maturing are now repricing off of depressed treasury, libor, and prime rates. Portfolio managers are reluctant to take on similar duration as previous positions due to low absolute levels of yields.
Regulator scrutiny, fear of inflation, and conservatism are all reasons why banks ae now positioned with asset sensitive balance sheets.
With short term rates essentially at zero, banks cannot really lower their cost of deposits. Furthermore, with competition fierce among banks for the credit worthy opportunities, loan margins are tight.
All else equal, these factors are all negative for NIM. Unless a resurgence of loan demand accompanied by strong loan pricing materialises, expect to see continued downward pressure on bank NIM’s in the foreseeable future. The obvious result of this will be incremental headwinds on bank EPS as they will be unable to materially cut expenses enough to offset this compression.