The title of my presentation was “Bracing for Rising Rates” and in it I covered three main topics. The first was to talk specifically about our 2003-04 interest rate risk model predictions and how they compared to actual bank performance for 2005-07. Next, I reviewed the specifics of the 2010 IRR Advisory that was released in January 2010. And finally I reviewed some current balance sheet trends. At the end of my presentation I shared these two conclusions:
1) The longer we stay in this low rate environment, the worse it will be for banks when rates do start to rise.
2) A small or gradual rise in rates will be worse than a big jump
We’ve already been in this environment for three years and there’s strong indications that we could be here much longer. Item #1 (above) worries me now more than ever. One reason is that I’m already reading stories of increased risk taking by community banks frustrated by narrowing spreads. One such story is the lead in the June 2011 issue of the American Banker’s Community Banking magazine. The cover caption reads, “Banks, newly flush with money to lend but seeing a lack of demand, will be tempted to take extra risks to fuel growth…”. Obviously they are talking about relaxing credit standards, but the point is they mention taking “extra risks”.
Aside from this anecdotal evidence, I see increased risk-taking in the data too, especially long-term interest rate risk. There has been a noticeable increase in EVE-at-risk over the past 5 years. While EVE at risk is an often misunderstood measurement, it does function very well as a barometer for long-term interest rate risk.
For banks with total assets between $100M and $300M the average EVE at risk moved from –12.6% in 2nd quarter of 2006 to –21.5% by 2nd quarter 2011. This is the first time the average has been over 20% since we started collecting peer data in 1994. It seems pretty clear that one of the reasons for this increase in risk is a change in total asset duration. Over the same period (2006Q2 to 2011Q2) average asset duration extended from 1.6 years to 2.2 years.
It appears that banks are investing longer term to capture some of their lost margin. Call it what you want - “going long” or “yield chasing” - it still means increased risk. And I’m afraid the longer we stay in this low rate environment, the more risk-taking (like this) we’re going to see.