INTEREST - RATE RISK : SURF´S UP / THE ECONOMIST ( VERY HIGHLY RECOMMENDED READING )

Interest-rate risk

Surf's up

Feb 25th 2010 NEW YORK
From The Economist print edition

Banks’ next big problem appears on the horizon

HOWARD ATKINS, the chief financial officer of Wells Fargo, a big American bank, recently said that he does not lose sleep worrying about interest-rate risk. But then, he joked, his job is so tough that it leaves him only one hour a night to nap.

Regulators, too, are getting restless. Last month a group of American agencies warned that banks need to sharpen up their management of interest-rate risk in readiness for a rise in short-term rates, which were cut to close to zero at the height of the crisis and remain there. They urged banks to plug a sudden rise of up to four percentage points into their stress tests.

Nobody expects anything quite so dramatic. The Federal Reserve still talks of keeping rates extraordinarily low for an “extended period”, a message reiterated by Ben Bernanke, the Fed’s chairman, in testimony to Congress on February 24th. Europe’s central banks are likely to follow America, not lead. But the surprise increase in the Fed’s “discount” rate for emergency loans to banks on February 18th, from 0.5% to 0.75%, has energised those who fret that rising interest rates may be banks’ next big problem.

The drastic rate cuts of 2007-08 greatly steepened the “yield curve”, the difference between short- and long-term rates (see chart). Banks have flocked to “surf the curve”, borrowing cheap, short-term funds and investing them in higher-yielding, longer-dated assets. This helped rebuild profits, but when short-term rates rise, banks may face a double whammy of dearer funding and less profitable assets.

Other factors could put upward pressure on banks’ funding costs even if monetary policy remains inactive. One is the increased competition for loans from governments as budget deficits balloon. Another is demand for funds from banks themselves, given how much debt they have to roll over in the next two years.

Analysts are busy trying to work out which banks will suffer from higher interest rates and which will benefit. “Asset-sensitive” firms, whose assets are of shorter duration than their liabilities and therefore reprice faster, tend to do well when rates rise. “Liability-sensitive” banks are more exposed to rising funding costs and see their margins squeezed.

Among big banks the picture is mixed. A 0.5 percentage-point rise in rates would cost Citigroup $771m in annual net interest income, reckons CreditSights, a research firm. Wells Fargo would gain by a similar amount. On a recent conference call, Mr Atkins said he is resisting the easy short-term profits from investing in long-term assets today in the hope of making a bigger killing when interest rates rise. The outlook for small banks is bleaker. Many have switched out of construction loans to longer-term mortgages, reducing their credit risk but increasing their interest-rate exposure because they are less able to reprice assets in line with funding costs.

Even those banks that are asset-sensitive must be careful. As rates rise, depositors will look for alternative investments, leaving them needing to find pricier replacement funding. “Banks are never as asset-sensitive as they think they are,” says Jason Goldberg of Barclays Capital.

Banks that are alert to the problem of interest-rate risk can also be surprised by the effects of changes in monetary policy. When a central bank begins to raise overnight rates, the yield curve generally flattens. In 1994, however, long rates rose by more than short rates for a while, clobbering investors who had positioned themselves wrongly.

The outlook for market rates is even more uncertain now because massive liquidity support has taken economies into uncharted waters. After amassing over $1 trillion of mortgage securities, the Fed will stop buying them at the end of March. Some think mortgage rates will leap by a full percentage point as a result, making life more difficult for borrowers. Others disagree. All worry that the eventual sale of these securities could wreak havoc.

Most banks would still place interest-rate risk some way down their list of priorities. Bad loans remain their top worry, underlined by news this week that the number of banks on the Federal Deposit Insurance Corporation’s “problem” list had jumped to 702, its highest level in 17 years. A sharper-than-expected fall in consumer confidence reinforced the chances that rates will be left on the floor for many more months. But when they do rise, they will trip up more than a few banks.

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