Bankers got what they wished for when the Federal Open Market Committee raised the federal funds rate by 25 basis points this week, but industry experts are warning that there are some downsides to higher rates.
For example, the rise in yields on short-term and long-term Treasury bonds can reduce the value of many banks' securities portfolios. Bond prices fall when yields rise, making the securities held in banks' portfolios less attractive to potential buyers.
Another effect is that hedges on various types of assets may now come home to roost. The $33 billion-asset BOK Financial in Tulsa, Okla., announced plans on Wednesday to record a charge to cover the negative result of hedging and one analyst predicted more banks will do the same in coming weeks.
Higher rates also mean that banks must eventually pay more to depositors. Mortgage-refinancing activity is expected to slow, meaning less fee income. Also, loan demand still remains pretty sluggish, and some industry experts say it will need to pick up before banks realize any meaningful benefit from rising rates,
"Everyone sees nothing but good" in higher rates, Frederick Cannon, global research director at Keefe, Bruyette & Woods, said in an interview. "Yields are up for banks and, all things equal, it will help net interest margins, but there are some offsets too."
If a bank's bond portfolio declines in value, the effect can manifest in different ways on the balance sheet. Earnings can take a hit if a bank sells securities at a lower value and realizes a loss on the transaction, or if the bank takes other steps to reposition its balance sheet, such as recording a charge to cover for reduced values, said Joe Fenech, an analyst at Hovde Group.
Equity levels could also fall as rates rise.
The yield on the benchmark 10-year Treasury rose to 2.525% on Wednesday and is up 66 basis points since Nov. 8. Yields on the 3-year and 5-year Treasury have also risen in recent weeks.
If rates rise further and bonds lose value, a bank's tangible book value and tangible common equity could take a hit, Brian Martin, an analyst at FIG Partners, said in an interview.
Banks that fit a certain profile are more likely to be hurt most by rising rates, Martin said. Those are institutions with a low ratio of loans to deposits, as well as a high level of securities classified as available for sale. (Securities classified as held-to-maturity are not affected by rising bond yields, because companies are not required to mark-to-market the value of held-to-maturity bonds at the end of each quarter.)
Banks in this category "have been benefitting for years because rates have been going down," Martin said. But the fourth quarter "is just the first quarter to see the change from the upside in yield. Some of the benefit they've gotten in the past will reverse."
Some bankers have managed their securities books with an eye toward the day when interest rates would be higher. It has taken years of patience, but the $118 million-asset Mississippi River Bank in Belle Chasse, La., should be in good shape, CEO Michael Bush said in an interview.
"Regulators teach you to ladder your securities portfolio, but the ladder has been lying on the ground for almost eight years," Bush said.
Starting in 2007, Mississippi River Bank sold all its holdings of Fannie Mae and Freddie Mac securities. Since then, the bank has shifted a large portion of its securities portfolio to held-to-maturity status, to provide a layer of protection against rising rates.
Now, about 61% of Mississippi River Bank's $26 million securities portfolio is marked as held-to-maturity, as of Sept. 30. That's higher than the average rate of 6% for its peer group, according to BankRegData.com. The setup gives the bank protection from the drop in bond prices, Bush said.
Other banks, such as the $141 billion-asset Fifth Third Bancorp in Cincinnati, have managed their fixed-income portfolios with the goal of being able to change course when the economy turns. Fifth Third's portfolio is significantly weighted more toward available-for-sale status than its peers. About 99% of Fifth Third's $30 billion securities portfolio was marked available for sale on Sept. 30. In contrast, the $134 billion-asset KeyCorp in Cleveland had 70% marked available-for-sale, and the $217 billion-asset BB&T in Winston-Salem, N.C., had 62% marked available-for-sale.
Although the strategy can expose Fifth Third to sudden swings in bond yields, Fifth Third plans to continue the tactic, Tayfun Tuzun, chief financial officer, said during an Oct. 20 conference call. That's because Fifth Third can quickly sell most of its securities and jump into another security type.
"Keeping nearly our entire investment portfolio in the available-for-sale category has also allowed us to maintain some flexibility to reposition the investment portfolio in response to changing market conditions," Tuzun said.
Then there's the issue of hedging. BOK Financial, the holding company for Bank of Oklahoma and Bank of Texas, will record a $17.4 million charge in the fourth quarter due to a $54 million loss on a hedge on its mortgage-servicing rights, partially offset by a $37 million increase in the fair value of the MSRs.
BOK Financial had placed the hedge position this summer, when rates dropped worldwide after the United Kingdom voted to exit the European Union, to counter the impact of falling rates. Since then, however, long-term rates have risen. It's a situation that's likely to repeat as many banks entered into rate hedges this summer, Fenech said.
"They put some hedges on around Brexit early in the summer and now obviously rates have moved sharply in the other direction," Fenech said. "I would characterize this as a downside of higher rates."
The rate hike should give a slight boost to banks' net interest margins, but without accompanying loan growth, the impact is likely to be minimal, said Dan Ryan, the head of the financial services advisory practice at PwC.
Ryan said bank CEOs are more interested in seeing policymakers cut the corporate tax rate as a way to stimulate economic growth. President-elect Donald Trump has said that reducing taxes on corporations would one of his administration's top priorities.
"Corporates haven't really been borrowing in a big way," Ryan said. "If there are no good loans to make, then the rate rise doesn't help. If you can spur economic growth where companies are actually investing again, then the rate rise is an immediate bottom-line booster."
Alan Kline contributed to this story.
