As everyone knows, it’s a tough time to be a banker. In an environment with historically low rates, compressed margins, increasing regulatory costs, and scarce opportunities for loan growth, bankers have been given a Goldilocks problem of managing their assets and liabilities so as to keep earnings robust while mitigating the ever-present threat of a sudden spike in interest rates.
The FDIC's Financial Institution Letter (FIL) 46 cautions banks against the risk of being too liability sensitive and too asset sensitive. Institutions are being asked to get the “porridge” just right, neither too cold nor too hot. On the liability side, there is the question of how to model core deposits in a competitive environment.
The FDIC is increasingly concerned that certain institutions may not be sufficiently prepared or positioned for sustained increases in, or volatility of, interest rates. For example, institutions with a decidedly liability-sensitive position could experience declines in net interest income and potential deposit run-off in a rising rate environment. Moreover, rate sensitive liabilities may re-price faster than earning assets. (1)
Sentiment in the banking community has been mixed with respect to likely deposit behavior, (2) but data indicate that the rate insensitivity of deposits is turning around after years of continual deposit growth, despite precipitous declines in rates. FDIC second quarter 2013 data indicate deposit balances have declined for two consecutive quarters. Total domestic deposit balances declined by $20 billion in first quarter 2013 and a further $31 billion in the second quarter. While time deposits are down overall, CD balances for maturities of three months or less are up. Institutions flush with deposits may be insufficiently prepared for how “hot” their core funding really is when rates finally begin to move.
Potentially exacerbating the problem is the need for institutions to go farther out on the yield curve on the asset side to protect against earnings stagnation in the current prolonged low interest rate environment. As far back as April 2013, the Financial Stability Oversight Council, echoing comments by Ben Bernanke, was warning against duration risk.
In the commercial banking sector, publicly available data indicate that the mismatch between the average maturity of assets and average maturity of liabilities has increased recently at smaller banks. ...While duration extension ...may boost near-term earnings, it could significantly increase losses in the event of a sudden yield curve steepening [or] a large rise in rates. (3)
Many financial institutions may find that although liquidity remains high, they are in need of term funding to defend against rising interest rates. In FIL-46 the FDIC affirmed its 2010 recommendation that institutions manage against interest rate shocks of 300 to 400 basis points.
Financial institutions have a number of approaches that can be used to mitigate risks associated with outsized exposure to interest rate risk. These approaches can include rebalancing earning asset and liability durations, proactively managing non-maturity deposits, increasing capital, and hedging. (4)
The FHLBI’s regular advance programs and occasional specials offer access to a variety of funding options to help manage members’ earnings while protecting balance sheets against possible rising rates.
(1) FDIC FIL 46, October 8, 2013
(2) For example, see John Reosti, "Deposit Pricing Creates Divide Among Bankers" Sept. 20, 2013, American Banker
(3) 2013 FSOC Annual Report
(4) FDIC FIL 46