Regulators Weigh Best Way to Curb Interest Rate Risk

WASHINGTON — The Basel Committee on Banking Supervision issued a proposal Monday laying out two options to deal with the growing potential threat from interest rate risk in the banking sector, with one entailing new minimum capital requirements and the other establishing strong supervisory benchmarks.

The plan seeks to deal with a fear among regulators that big banks are not adequately prepared for what happens when interest rates, which have been at record low levels in the U.S., begin to rise. The proposal would apply to large, internationally active banks with more than $250 billion of assets, including JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo, although domestic regulators could potentially apply them more broadly.

Almost as soon as it was released, some industry representatives blasted the plan, saying that though the threat of interest rate risk is "real," new standards will "confuse" efforts to manage that risk.

"The Basel Committee is once again proposing an overly prescriptive approach to address an issue on which banks and their regulators have already been working," said Frank Keating, the president of the American Bankers Association. "Rather than the Basel Committee's heavy-handed and prescriptive global framework, U.S. regulators should continue to take a supervisory approach that allows local regulators to consider each bank's specific positions and sensitivities."

The proposal seeks comment on which direction regulators should head.

Dealing with interest rate risk via new capital standards would have the benefit of making new rules globally uniform and comparable across institutions, fostering market confidence and a level playing field at the same time, the committee said.

On the other hand, a supervisory approach would "better accommodate differing market conditions and risk management practices across jurisdictions" and could be made more uniform and comparable if it was based on a "required calculation of a standardized framework," the proposal said.

The committee will accept public comments through Sept. 11 with the purpose of "narrowing down its policy options" after that. Among the areas that the committee is seeking input on are how strict either standard should be, whether interest rate risk from covered institutions should be publicly disclosed, how the new standards should interact with banks' internal interest rate controls and other technical considerations.

Interest rate risk is best understood as the risk posed by having a mismatch between the interest rates being paid by an institution and the rates of revenue being generated by existing assets. Since the crisis, many banks have been doing much of their lending at very low rates and investing in low-yield products since the Federal Reserve's ultra-accommodative monetary policy has kept cash out of traditional deposit accounts.

That mismatch was amply illustrated in the mid-1980s in the savings and loan crisis, when thinly-regulated and capitalized thrift savings banks courted depositors with double-digit interest rates in order to take advantage of the high federal funds rate, while receiving little from existing mortgages. When rates fell, scores of thrifts failed, costing billions of losses and a long-lasting drag on the economy.

Many in the financial sector fear that when the Fed raises the federal funds rate — probably sometime this year — it could lead to a significant mismatch because banks will be forced to pay out higher interest rates on deposits while being tethered to a vast portfolio of low interest-yielding bonds and mortgages.

Karen Shaw Petrou, managing partner at Federal Financial Analytics, said that regulators in the European Union are pushing for the capital-based framework for interest rate risk because it would bring banking rules more in line with existing capital rules on other activities like trading. A uniform capital charge would also provide an opportunity to apply some measure of risk-weighting to sovereign and other low-risk assets, which banks are holding in vast reserves.

The U.S., meanwhile, addresses some of this risk with its leverage-based capital rules, which is spurring it to favor a more prudential approach, she said — requiring banks to not engage in lending that exceeds some standard ratio between interest rates paid versus interest rates received.

"This is an area where the appropriate response really varies depending on which country you're in," Petrou said. "The U.S. has been on one side and the U.K. and EU and others on the other in terms of what they want to do, and that's why they have two options in this proposal, because they simply could not agree."

Greg Lyons, partner at law firm Debevoise & Plimpton, said that the proposal fits in with a larger regulatory pattern at the Basel Committee, which has been to push for standards that are comparable and uniform, but also rigid. Interest rate risk is precisely the sort of risk that has traditionally been managed by banks in-house, he said, and in combination with other capital rules, an additional interest rate risk capital rule would be unnecessary and harmful.

"The question will be … does the desire for a standardized [approach], which is clearly the trend elsewhere … win the day?" Lyons said. "Or is this either not seen as a significant enough risk to warrant that kind of treatment, or a diverse enough risk that they feel more comfortable allowing for greater [discretion]."

Jaret Seiberg, an analyst at Guggenheim Securities, said that even though the final Basel rule is unlikely to emerge before 2016 and a final rule from U.S. regulators won't come until even later, regulators could informally enforce an interest rate capital charge or ratio as part of its qualitative bank examinations associated with the Comprehensive Capital Analysis and Review process.

"As part of the capital planning process in CCAR, big banks need to be planning for these types of rules," Seiberg said. "As a result, this could put downward pressure on distributions. Also, some banks may respond to the plan by reining in their interest rate risk in advance of Basel's rulemaking. That could hurt earnings in the short term."

Petrou said that the interest rate risk environment we're experiencing now could itself be the result of banks having to hold large amounts of high-quality liquid assets because of existing capital and liquidity rules. Because sovereign bonds have a zero risk weight, there are new liquidity rules and few other promising investments, the regulators may have pushed banks into a situation where they face an outsize interest rate risk when the federal funds rate rises.

"You have a lot of banks sitting on very large volumes of long-term, low-return government bonds and other instruments … partly because there are not a lot of opportunities to lend," Petrou said. "No credit risk, but a lot of interest rate risk when deposit rates start to rise."