Is the Show About to Start?

The banking industry and its observers have been talking about it since the U.S. officially emerged from the financial crisis and the follow-on Great Recession --- When are interest rates going to begin to normalize and, given that we used several novel (and untested) monetary policy tools in the U.S., will the path to interest rate normalization be fraught with unanticipated negative consequences for the banking industry?

The government-administered suppression of short-term interest rates through the Federal Reserve's Zero Interest Rate Policy (ZIRP) and its half-nelson push-down on rates along the longer end of the yield curve through three cycles of quantitative easing (QE) seems to be coming to a close.  The Federal Open Market Committee's (FOMC) own consensus projections show 2015 as likely to herald the first upticks in the federal funds rate in many years.

After seeing a significant drop in the headline unemployment rate over the last year to 6.1% (busting through Ben Bernanke's 6.5% reference point), last week Fed Chairman Janet Yellen, in congressional testimony, uttered a phrase - a  caution really - that should reverberate in the sanctums of bank Asset-Liability Committees (ALCOs) across the globe:

“If the labor market continues to improve more quickly than anticipated by the Federal Open Market Committee, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target likely would occur sooner and be more rapid [my emphasis] than currently envisioned,”

Also trying to make the case that the old show might soon be over and that the new show might be potentially surprising, are the respected intellects at Cumberland Advisors, who noted in a recent analysis piece - "Tapering is Now Tightening", that beginning this month, Federal Reserve System purchases of government debt falls below the volume of monthly U.S. government debt issuance.  The Fed is no longer fully absorbing new U.S. government debt issuance.

In a related piece, entitled "Hope is not a Strategy", they also present the case that the odds of a significant and surprising spike in interest rates, rather than a more interest rate risk-manageable moderate ramping-up of interest rates, may not be inconsequential.

For community banks, the emerging visibility of an interest rate tipping point, is a better news/bad news scenario.  The better news is that macro-structural net interest margin compression may ease up.  Banks have been suffering ongoing and painful net interest margin compression over the last few years, caused largely by the Fed's repression of interest rates, yield curve flattening, and the dropping loan volumes suffered during the economic decline phase of the Great Recession. Thankfully, at least loan volumes are slowly rising again.

This suffering has prompted many community bank boards of directors, particularly those in competitive and price-sensitive geographies, to seriously consider throwing in the towel and trying to sell out.  Rationally thinking that a reasonable return to stockholders in this environment appears out of reach -  at least without taking imprudent risks or taking on the uncertain payback of re-engineering their business models.  The noxious brew of net interest margin compression, flat non-interest revenue, and escalating non-interest expenses - largely due to new (or more forcefully emphasized) regulatory expectations has changed the underlying economics of the small community banking model.

It's only small consolation to the average community bank that there was a partial offset to margin compression via increased liquidity and safety preferences on the part of anxious consumers and businesses.  Surging pools of non-maturity transaction deposits helped lower the interest expense side of the net interest margin equation.

Enter the latest Semiannual Risk Perspective recently issued by the Office of the Comptroller of the Currency.  Unlike its previous editions, where its counsel regarding interest rate risk could be likened to a yellow flashing caution light; the tone of the current edition changes to a red flashing warning light - stop and look both ways before proceeding.

Previous editions of the Semiannual Risk Perspective repeatedly warned community banks against engaging in what I'll call "down and out banking" - attempting to increase asset yields by moving down the credit quality scale to fund less-creditworthy obligors and by moving out along the yield curve by extending maturities in order to capture incremental yield.  In one case, as rising rates impact variable-rate portfolios (or short maturity fixed rate), it's a formula for transforming interest rate risk into credit risk as marginal borrowers cope with the stress of higher debt service requirements.  In the other case, you flirt with underwater securities portfolios and the liquidity and credit-risk issues that come with the territory.

The Semiannual Risk Perspective makes a teachable moment out of this by highlighting a couple of sobering statistics - National banks with less than $1 billion in total assets have increased long-term asset concentrations from 17% in 2006 to 31% at year-end 2013 --- almost a doubling.  And by the way, that's an average.  I'd love to see the median long-term asset concentration and the range, so that we could get some visibility about where the top half lives.  Any call report data miners out there?

Moreover, strong deposit inflows, uneven loan growth, and net interest margin pressure has created a situation where the growth in investment securities portfolios in those same banks has been centered in mortgage-backed securities - creating the potential for duration extension in a rising rate environment.

And let's not forget the bank capital management gymnastics that will come from the new capital rule effective January 1, 2015.  Smaller banks have a one-time, irrevocable option to neutralize certain Accumulated Other Comprehensive Income (AOCI) components - essentially unrealized gains and losses on available-for-sale securities.  If the option is not selected, AOCI will be incorporated into the Common Equity Tier 1 capital ratio.

This AOCI neutralization creates both "shadow capital" - market value gains that could be converted into measured regulatory capital at the expense of the future income stream - and "shadow losses" - market value losses that could erode measured regulatory capital if liquidity or other risk management imperatives forced the unexpected disposition of some, or all, of these available-for-sale securities.  This "shadowy" regulatory capital treatment needs to be incorporated into real world capital planning, including in stress test scenarios.

Lastly, there's the issue of  "The Surge" in non-maturity transaction deposits and how elastic those balances will be in a rising interest rate environment.  Historical balance analysis has only limited benefit as we are in uncharted waters here.  In a ZIRP and QE environment, there is little opportunity cost to a consumer or business to keeping a boatload of cash idle in a transaction account at a bank.  That equation changes in an interest rate normalization scenario.  How it changes remains to be seen.  But one thing is probably sure, human nature tends toward the hopeful outcomes in life and probably in interest rate risk modeling too... and as the folks at Cumberland Advisors mentioned - hope is not a strategy.

For important background regulatory guidance documents on interest rate risk, please consult the 2010 interagency Advisory on Interest Rate Risk Management and the 2012 update Frequently Asked Questions.

Note to Readers:  Thank you for bearing with me during this period of radio silence on The National Bank Examiner blog.  Under the theory that two tires on the same axle go bald at a similar rate, I had to have surgery to replace my other hip joint.  Result: a wonderful success.  Goodbye to the chronic pain of arthritis.  Thank you, Dr. Courtney Sherman, of the Mayo Clinic in Jacksonville, Florida!