The U.S. Federal Reserve Board’s plans for the next round of bank stress tests highlights the increased importance of an interest rate risk, says Fitch Ratings in a new report.
The rating agency says that the Fed’s recent disclosure of the key economic assumptions to be used in the upcoming round of stress tests “reflects the heightened importance of interest rate shock scenarios for both regulators and banks.”
Each of the Fed’s scenarios includes 28 economic variables, capturing hypothetical changes in interest rates, asset prices and economic growth in the U.S., Europe, Japan and developing Asia, Fitch says. “But we see the interest rate risk component as particularly important in the next supervisory review, given the risk that a tapering of Fed bond purchases over the next year could again push long-term rates significantly higher in a short period of time,” it notes.
Fitch points out that in the second and third quarter this year it was shown that a rapid rise in long-term rates can drive a quick swing in the balance of unrealized gains and losses in U.S. banks’ portfolios. It notes that when the 10-year yield rose by approximately 150 bps during the second and third quarters, unrealized gains dropped to negative US$10.5 billion from over US$30 billion for the large banks.
“That value has since recovered to approximately US$8 billion, but illustrates the sensitivity of investment securities’ values to rising interest rates, and the potential impact on Basel III and tangible capital levels,” it says.
The only scenario where interest rate risk may not be central is the “severely adverse” scenario, it says, which would include a sharp global economic slowdown, with a severe recession in the U.S. pushing the unemployment rate above 11% by mid-2015. “In such a scenario, interest rate risk would likely take a backseat to severe asset-quality weakness as a potential driver of bank stress,” Fitch says.