Do you get the sense that over the next year we’re going to see which banks have been swimming without a bathing suit? Federal Reserve Chairman Ben Bernanke signaled recently that the central bank will soon begin to tighten its monetary policy and allow interest rates—which have been at historically low levels now for quite some time—to begin to rise. What this means for the banking industry is unclear. It will probably be a mix of good and bad, although whether it’s ultimately more bad than good, or more good than bad, remains to be seen.
What seems clearer to me is that the best performing banks over the next year or two will be those whose leadership teams—which include a forward-looking board of directors—have done the best job of managing interest rate risk and preparing for a day that ultimately had to come. We saw which banks had the best leaders during the financial crisis from 2007 to 2009, and I think the next year or two will be another—if less severe—test of leadership.
Last June, Bernanke said at a press conference that if U.S. economic growth continues and unemployment declines further, the Fed would begin “later this year” to reverse its monetary policy of pumping liquidity into the economy through monthly purchases of U.S. Treasury and agency mortgage-backed securities, which it has been doing since the financial crisis. Under this rosy scenario, the Fed would end its bond purchases by mid-2014. Predictably, the markets reacted sharply and swiftly to his comments and the interest rate on long-term Treasuries began to rise, which has put some upward slope back into the yield curve.
What does this mean for banking? Higher rates wouldn’t necessarily be bad for the industry if the U.S. economy has finally regained its footing. A stronger economy is good for banks since it usually means better borrowers, and more of them. And higher interest rates would allow banks to charge more for their loans.
But while higher rates might not be bad for banking, it could be bad for many banks. Former Federal Deposit Insurance Corp. Chairman Sheila Bair told Bloomberg News in early July that she worried about banks that have sold large amounts of interest rate swaps, because no one knows whether their hedging strategies will work. Banks that have accumulated large bond holdings might also see the value of their portfolios plummet as rates rise, which would force them to take write-downs. And banks that are overly reliant on rate sensitive deposits will also see their funding cost rise over time, which could be a problem if their deposits re-price faster than their loans. This is a classic asset/liability mismatch of the sort that banks have always tried to avoid, and you can bet this time around that some banks have managed to mismanage it.
Still, higher rates won’t be bad for all banks. Institutions that have maintained a high percentage of low-cost core deposits will be much better protected against a rise in funding costs than those that haven’t. And banks that maintained underwriting discipline when the commercial loan market softened last year and avoided booking a lot of thinly priced credits will see the margin benefits of higher loan rates sooner than those that didn’t. Indeed, this is a great time to be an asset-sensitive bank.
I think there is a certain kind of institution that will come through this transitional period to higher interests rates in fine shape. It will have a strong leadership team and be conservatively managed, with a high level of capital and industry-leading risk management skills. It will fund its operations as much as possible with stable core deposits and will design its retail and commercial strategies around that goal. And it will focus much of its lending on niches and industry specialties that avoid the trap of commodity pricing while also creating an opportunity to develop complementary fee-based services.
Do banks like this actually exist? You better believe it. And while Ben Bernanke worries about how to wean the economy off of cheap credit, the management teams and directors at these institutions will handle it all in stride. The tide might be going out, but they’re all wearing bathing suits.