By Robert B. Segal
Over the past five years, financial institutions have operated in a setting of historically low interest rates. These conditions have influenced changes in asset mix while presenting challenges to maintaining profitability. As interest rates declined, the yield curve steepened, prompting many institutions to rely more heavily on longer-term loans and securities to support profitability. According to a recent report by the FDIC, these changes in balance sheet composition appear to have resulted in increased interest rate risk exposure.
Asset expansion since 2008 has primarily been the result of growth in bank securities portfolios, according to the FDIC. Securities balances grew by a larger dollar volume and at a considerably faster pace than loans during the five years ending second quarter 2013. During this period, the annual growth rate of securities far exceeded the increase in loans (8.2 percent vs. -0.4 percent).
Securities as a percentage of assets increased from 14.7 percent to 20.2 percent for institutions with assets over $1 billion and from 18.5 percent to 23.1 percent for banks under $1 billion. Even as smaller banks increased securities holdings, they’ve also shifted to securities and loans with longer maturities. Since second quarter 2008, longer-term assets (loans and securities with maturities or repricing dates greater than five years) increased from 19.9 percent to 28.8 percent.
Long-term securities represent 13.0 percent of assets and more than half of all securities held by smaller banks. Long-term loans represent 15.8 percent of assets. Meanwhile, larger banks have only slightly increased longer-term assets, from 19.3 percent to 20.7 percent. Although it is difficult to predict when interest rates will increase, the FDIC guidance urges banks to prepare for a period of rising interest rates. The report said the value of longer-maturity securities may decline as interest rates increase, putting banks’ earnings, liquidity and images in jeopardy.
Keeping Risk Down
To reduce risk, the FDIC recommends that banks consider boosting their holdings of shorter-maturity or variable-rate securities and lock in profits by selling longer-term securities. Banks that have extended asset portfolio duration to capture higher yields may find that variable-rate products are more effective in managing sensitivity and mitigating potential depreciation in the portfolio.
While a shift to floating-rate assets certainly helps to reduce interest rate sensitivity, this comes at a cost. At the December 2013 FOMC meeting, the Fed reaffirmed its view that highly accommodative monetary policy will remain appropriate for a considerable time after their bond purchase program ends and the recovery strengthens. The Fed anticipates the target range for federal funds will remain at 0 to 25 basis points until “well past the time” that the unemployment rate declines below 6.5 percent.
A wide range of indicators implies that the first increase in the target federal funds rate will occur during the latter stages of 2015. Based on trading in short-term interest rate futures, the Fed will raise rates no earlier than the third quarter of 2015. A majority of Fed governors and district presidents see the first hike in 2015. Of this group of 17, only two look for an increase this year, while 12 expect it to happen in 2015 and three in 2016. Most policymakers say the rate will stay below 2 percent through the end of 2016. In this environment, floating-rate assets may provide 2 to 2.50 percent less yield relative to comparable fixed-rate assets for a period of two or three years. Most institutions still need to generate interest income, and a large allocation to floating-rate assets could impact earnings.
If the Fed in fact does not raise rates for two years, then fixed-rate assets put on the books today will earn a positive carry relative to the federal funds rate. Four- to five-year average life assets would perform well on a relative basis, because these instruments should have “rolled down” the yield curve by the time the Fed acts. This feature provides some price protection in a rising rate environment, as the assets will be shorter-term when rates start to rise.
As the Fed pares back on its bond purchases this year, longer-term interest rates may continue to climb. It is sometimes challenging to add assets in this kind of environment, because bankers could find these assets to be underwater in the near term. With regulator concern over mark-to-market pricing and balance sheet fair value testing, the goal is selecting those instruments that will not exhibit excessive price volatility. This means avoiding extension risk in the investment portfolio and making sure commercial loans are structured appropriately. As always, institutions should maintain robust risk management practices, keeping interest rate risk exposure at reasonable levels.
Robert B. Segal is president of Atlantic Capital Strategies Inc.