Fueled by higher volumes of long-term mortgages, small- and medium-sized banks are becoming more vulnerable to risks when interest rates shift higher in coming months. And these institutions should begin to take precautions, said the Federal Deposit Insurance Corp. today.
In an article titled, “Nowhere to Go but Up: Managing Interest Rate Risk in a Low-Rate Environment,” the FDIC warns that current loan portfolio strategies among these institutions “could prove troublesome” with a significant increase in interest rates. The article appears in FDIC’s publication, Supervisory Insights, and is available on the regulatory agency’s website.
This month marks the first anniversary of the record low Federal Funds rate, 0.0-0.25 percent. But most analysts agree that the Federal Reserve will likely nudge rates upward as the economic recovery becomes fuller and more widespread well into next year.
Recent FDIC findings “suggest financial institutions are becoming increasingly liability sensitive and, therefore, more exposed to increases in interest rates,” the FDIC said.
Factors contributing to heightened interest rate risk include:
- earnings pressure to offset losses and higher loan-loss provisions;
- elevated volumes of longer-term assets, primarily mortgages, held in portfolios;
- heavy reliance on short-term and wholesale funding sources that are generally more rate-sensitive and less stable than traditional deposits.
More financial institutions are holding higher volumes of longer-term assets, the FDIC said.
“For almost 20 percent of banks, longer-term assets comprise more than half of assets,” the FDIC said. “This is up from 2006, when longer-term assets made up the majority of assets at only 11 percent of banks.”
During the past several quarters, small and mid-size financial institutions have increased their exposure to long-term mortgage loans and mortgage-related securities, and have reduced concentrations in commercial and development loans, a precarious sector rife with increasingly failing loans.
Although this shift is critical to managing credit risk, replacing commercial and development loans, which tend to have a shorter duration than mortgage assets, with assets that have similar re-pricing characteristics has been challenging.
“The shift in the asset mix increases the interest rate exposure of many institutions, especially those with less than $10 billion in total assets,” the FDIC said.
The FDIC is urging financial institutions to plan for likely increases in interest rates and take steps to mitigate and control the associated risks. Concentrations of longer-maturity assets, funded with shorter-maturity liabilities, can stress an institution’s earnings, liquidity, and capital in a rising rate environment, the FDIC said.
Financial institutions should effectively manage the risk of declining yield spreads between longer-term investments, loans, and other assets and shorter-term deposits and other liabilities.
“If capital and earnings provide insufficient protection against adverse changes in interest rates, a bank should take steps to reduce its IRR exposure, increase capital, or both,” the FDIC concludes.