The Federal Reserve will release the first batch of stress-test results this week and among the many things investors and other industry observers will be watching for is how prepared banks are for the prospect of interest rates falling below zero.
It's a purely hypothetical scenario — there are lots reasons for the Fed to keep interest rates above zero — but the stress tests are about planning for the most adverse economic conditions. So, for the first time, the Fed this year is requiring the 33 banks subject to the stress tests to show how they would cope with the possibility of rates dipping into negative territory.
Results from the Dodd-Frank Act Stress Test are scheduled to be released on Thursday, and the results from the more vigorous and intensive Comprehensive Capital Analysis and Review will come June 29. Both tests are required for banks with at least $50 billion of assets.
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Federal Reserve Govs. Jerome Powell and Daniel Tarullo Thursday said they expect banks to have to meet significantly higher capital minimums after the central bank applies its capital surcharge rule for large globally risky banks to its stress test. That difference could significantly cost banks.
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Other countries have already lowered interest rates below zero, and the financial stability concerns of such a policy taking shape in the U.S. should not be dismissed.
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WASHINGTON Large banks will simulate their ability to weather both deflation and a recession among the annual economic scenarios provided by the Federal Reserve Board on Thursday for the central banks 2016 stress tests.
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Analysts say they will be keeping a close watch on the most asset-sensitive banks, which tend to be hit hardest when rates fall.
Included in this group are the nation's three custody banks — Bank of New York Mellon, State Street and Northern Trust — and a number of regional banks that have high levels of loans that would reprice faster than liabilities.
For example, the $69 billion-asset Comerica, in Dallas, has high levels of commercial loans and core deposits, he said. In a negative-rate situation, Comerica would not get a benefit from a spike in yield from its commercial loans, which are generally tied to the London interbank offered rate, and its funding costs would increase, said Scott Siefers, an analyst at Sandler O'Neill.
"Comerica would get hit by both the absence of a tailwind and the introduction of an unprecedented headwind," Siefers said.
Another reason regionals might be hurt by negative rates is because they lack exposure to international markets, where some jurisdictions have implemented negative rates, said Jason Goldberg, an analyst at Barclays. Banks with overseas operations have thus already had to upgrade their systems and business models.
"Their stress modeling systems might not be as equipped to handle negative rates, relative to the bigger banks that operate in multiple countries," Goldberg said.
Meanwhile, Bank of New York Mellon, State Street and Northern Trust all would be hurt by negative rates because much of their lending, typically to other banks, is short-term and reprices faster; thus, they would be forced to swap positive-rate loans for negative-rate loans.
The trust banks also would be forced to waive fees on money market funds because, otherwise, they would be asking investors to pay them to hold their money.
Both Goldberg and Siefers said that they expect asset-sensitive banks to pass stress testing, although any could be directed to resubmit tests with altered plans or adjusted dividend or repurchase requests.
As a general rule, banks decline to comment on stress testing while results are pending.
Of course, all banks would be hurt to some degree by negative rates. Negative short-term interest rates can compress a bank's net interest margins, which can lead to lower pre-provision net revenue (PPNR), Goldberg said. PPNR is a bank's earnings stream before credit costs are taken out.
"When you talk about loss-absorption capacity, PPNR takes on immediate significance," Siefers said. "You want to show that you have this income stream that can withstand the shock. But when you insert negative rates into it, you are really limiting how much PPNR cushion you have."
While analysts may have an educated guess which banks will get their hands slapped, it's extremely difficult to forecast how negative rates will affect any bank, Paul Burdiss, chief financial officer at the $58 billion-asset Zions, said at the Salt Lake City company's investor day in February. Some banks may raise fees or add new surcharges to compensate, he said.
"It's such a complicated question to answer," Burdiss said. "The impact on deposit pricing is very difficult to predict. You've got the opportunity to increase fees, for example, on deposits, particularly commercial deposits. So you may have a floor at zero, but maybe you've got a fee as an offset to that."
The negative-rate scenario has also raised technology expenses for banks, as they have had to upgrade compliance and data systems. Even though it will increase costs, it's a worthwhile task, Siefers said.
"It speaks to the robustness of what a system can handle," Siefers said. "You're introducing a new rate paradigm into your systems, and that's a good thing. It's better to test your systems out when you don't need to, rather than making them up on the fly."
Some bankers say they doubt that the Fed would actually take rates into negative territory because of the potentially devastating effects on the economy.
"If you think about the liability structure that insurance funds and pension funds have, negative rates would do great damage to funded ratios for those kinds of companies and entities," Aleem Gillani, chief financial officer at the $190 billion-asset SunTrust Banks, said during a March 8 investor conference. "And then of course, we don't know [if the Fed] is constitutionally able to pay to move to negative rates on interest on excess reserves anyway."
But don't completely rule it out, either. Japan, Switzerland and other central banks have all pushed rates below zero. Many experts predicted that the Fed would have raised rates at least two or three times this year, but it has taken no action since it lifted rates by 25 basis points in December.
"The risk of the Fed prematurely raising interest rates at this point is extremely low," Neil Dutta, head of U.S. economics at Renaissance Macro Research, wrote in a research note. "They are going to let this cycle lengthen and strengthen by keeping rates low."
