When the prolonged low interest rate environment finally comes to an end, this shift may have a meaningful impact on banks’ capital and earnings, suggests Fitch Ratings.
In a new report, the rating agency notes that the recent rise in U.S. Treasury yields and speculation about possible changes in the Fed’s bond buying program are highlighting the potential risks faced by U.S. banks in a rising rate environment.
For one thing, it says a sustained increase in interest rates could hamper bank capital under the current proposed Basel III framework.
“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 says.
It suggests that if the Fed exits 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, it says, “we see the potential for further declines in bond prices, with losses potentially larger on a percentage basis than those reported during the credit crisis.”
Additionally, Fitch says that while most banks expect net interest income to rise along with interest rates, it suggests that the magnitude of these changes could be vastly different than expectations, “depending on how depositors and borrowers actually behave as rates rise.”
“Even as the Fed raises short-term rates, margins could remain depressed if long-term rates do not follow suit,” it says. “This would result in a flattened yield curve, potentially leading to an outcome similar to that experienced during 2004-2006.”
And, it suggests that asset quality could deteriorate as rates rise, 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,” it says.
Fitch says that it does not believe the impact of rising rates will create solvency issues at U.S. banks. However, it warns that negative rating actions could emerge if it detects “an absence of risk management practices commensurate with balance sheet strategies that could result in adverse impacts to capital and earnings as rates rise.”