Daily News: June 19, 2013

Fitch: Market Moves Bring Interest Rate Risks to Forefront

The recent rise in U.S. Treasury yields and speculation surrounding possible changes in the Fed’s bond buying program have highlighted the potential risks faced by U.S. banks in a rising rate environment, according to Fitch Ratings. A sustained increase in interest rates, potentially signaling an end to the prolonged low rate environment that has hampered bank margins, could have a meaningful impact on capital and bank earnings.

Fitch said it remains primarily focused on the adverse impact that rising rates could have on bank capital under the current proposed Basel III framework for U.S. banks. Unrealized gains on securities held on U.S. bank balance sheets have risen to historically high levels, potentially setting the stage for a reversal of gains and an ensuing erosion of capital levels should rate increases hit bond prices hard. This is especially relevant given banks’ increased exposure to mortgage bonds in investment portfolios on both an absolute and proportional basis.

Fitch said it recognized that the realized impact to capital will largely be driven by how the Fed may exit the quantitative easing program. If the Fed were to exit its bond buying strategy in a gradual and transparent fashion, the impact on bond prices could be less significant. However, to the extent that this does not occur, Fitch sees the potential for further declines in bond prices, with losses potentially larger on a percentage basis than those reported during the credit crisis.

The vast majority of Fitch-rated banks have disclosed that they are asset-sensitive, meaning net interest income (NII) rises along with interest rates, as assets re-price faster than liabilities. While Fitch believes that most income simulation models are likely directionally sound, the magnitude of NII changes could be vastly different than modeled outcomes, depending on how depositors and borrowers actually behave as rates rise. This is particularly relevant given the unprecedented length of time during which rates have remained at historically low levels.

Even as the Fed raises short-term rates, margins could remain depressed if long-term rates do not follow suit. This would result in a flattened yield curve, potentially leading to an outcome similar to that experienced during 2004-2006. In addition, rising rates may put additional pressure on banks with longer-duration balance sheets to pursue mergers with shorter-duration banks that will be better positioned to maintain earnings in a rising rate scenario.

Fitch said it believes that asset quality could deteriorate as rates rise, causing cap rates to increase, leading to lower commercial real estate values. Moreover, borrowers that were unable to lock in long-term, fixed rate funding will be burdened with greater debt costs, potentially leading to higher default rates.

In general, Fitch said it expects most banks’ margins to expand along with rising rates. This view is incorporated in Fitch’s outlook for the banking industry. Fitch does not believe the impact of rising rates will create solvency issues at U.S. banks. However, negative rating actions could emerge if Fitch identifies an absence of risk management practices commensurate with balance sheet strategies that could result in adverse impacts to capital and earnings as rates rise.

To read the full eleven-page Fitch report click here.