Inside Business
Last updated: June 17, 2013 5:39 pm
Inside Business: Rising rates carry different risks for US Banks
The interest rate cycle is the next biggest fear amid wider concerns over bank lending
As the new chief risk officer of JPMorgan Chase, Ashley Bacon is a man paid to worry. But it is still useful to glean what precisely he is worrying about.
“It could be a shockwave when the bond market eventually turns,” he told me last week. “We have to be prepared. I think the interest rate cycle is the next big one and, for a long time back, we’ve been thinking about that – and we continue to update the analysis.”
This has to be the most anticipated risk in recent financial history. Warnings of rising interest rates have abounded ever since the Fed moved them to their current exceptionally low levels. But no matter how much today’s jittery credit markets may be anticipating rising rates, they will still catch out at least one bank.
Given that there are 7,000 banks in the US, the betting is that one of them has lent or invested at yields too low to weather an increase in funding costs.
The consequences depend on how high up the banking pyramid the mistake occurs. For the good of the economy, investors hope it will be a considerable distance down from JPMorgan, Bank of America and Citigroup, the top three US banks by assets.
This is the most likely outcome, for a number of reasons.
First, there is a broad echelon of smaller banks and they can’t afford Ashley Bacons (although they don’t have traders like JPMorgan’s ‘London whale’ racking up trading losses, either).
Second, the smaller banks have been engaged in an uneven fight for customers. A senior loan officer based in California told me recently that she was seeing “desperation moves” by smaller banks offering 10-year commercial loans at less tan 4 per cent.
Then there is the effect on the borrowers. “Something that I worry about is that a lot of businesses have got used to a very low interest rate environment and built a business model around that,” the loan officer added.
Such talk by the giants is self-interested, perhaps. But the differences between big and small banks is worth watching. A lot of time has been spent in Washington this year debating banks that are “too big to fail”. Many have questioned whether the top players enjoy cheaper funding because of implied government backstops, and have been proposing a variety of new taxes on size and complexity.
Hundreds of community banks, organised by the Independent Community Bankers of America, have been knocking on the doors of Congress to demand tougher regulation on their rivals, and lighter rules for themselves.
This has only taken on momentum because small banks feel threatened in their day-to-day business.
Consider their customers. A company with a $5m-$20m turnover, of which there are about 300,000 in the US, looks outward more than in the past, buying or selling goods and services overseas. They prefer a big name bank with a presence in multiple states, technology that can help to manage their cash flow, and an ability to deal with foreign exchange inquiries. Smaller banks find it hard to compete for that business on any of these grounds. But they can offer you a cheaper loan.
Seven thousand banks is more than most other developed economies but it is about 1,000 fewer than at the start of the financial crisis and it has almost halved in 20 years. Consolidation will continue, not rapidly but unwaveringly, and those who have offered cheap loans in an ill-judged push for business face a reckoning.
Of course, that does not mean bigger banks are immune from such an interest rate miscalculation. JPMorgan, for one, is going to have to wait some time to rebuild its reputation as a savvy risk manager.
However, the bank’s disastrous investments in credit derivatives last year at least underlined how wary it was about interest rates.
JPMorgan could have invested all of its $350bn of excess deposits in Treasuries. But that would have left it exposed to interest rate risk. It could also have earned 10 times the yield it is getting on the $100bn it has parked at the Fed, which is paying 25 basis points of interest.
But it is willing to sacrifice a few billion dollars for the flexibility that this provides. If the Fed raises rates, the central bank will look to pay more on these excess reserves, hedging the bank against dislocation in the bond market.
Even so, that still leaves two risks in the interest rate cycle that must trouble Mr Bacon and his counterparts. One is that banks misjudge it. The other is that – as with the ‘London whale’ – they take evasive action only to encounter new risks that are less understood.
Tom Braithwaite is the FT’s US Banking Editor
Copyright The Financial Times Limited 2013.
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