• Rising interest rates are adversely affecting bank investment portfolios, leaving banks with a difficult set of choices.
• Regulators increasingly are expressing concern with the effect of interest rate risk.
• Banks must ensure their risk management, strategic, and operating plans adequately address interest rate risk and potential decrease in the quality of their credit portfolios.

Office of the Comptroller of the Currency, Federal Reserve, and Federal Deposit Insurance Corporation Warn About Interest Rate Risk

On December 15, the Office of the Comptroller of the Currency (OCC) published its Semiannual Risk Perspective, highlighting the risks associated with the sharp Federal Reserve rate increases—4 percent in 2022 alone. After an extended period of historically low rates, the increases after years of warning have begun to adversely affect the value of bank investment portfolios as well as the conditions of bank customers and partners.

The warning from the OCC was clear and addressed banks of all sizes, but particularly smaller and midsize banks with less diverse portfolios and potential market and product concentrations. “Banks with assets less than $50 billion are projecting, on average, about a 4 percent decline in portfolio values for every 100-basis-point rate increase,” according to the regulator’s report.

The stress caused by lower portfolio values leave banks with a set of difficult choices.

Each quarter, banks are required to report the fair value of their available-for-sale securities. Banks balance sheets are adversely affected when those assets decline in value because of market conditions while liabilities and cost of funds increase. If these assets get marked down but liabilities remain constant, then this could adversely affect a bank’s generally accepted accounting principles (GAAP) equity and its access to liquidity. Banks with negative tangible equity are not eligible for Federal Home Loan Bank advances without a waiver from their primary federal regulator. Such advances are important for many banks.

The severity of the impact on a bank depends on the exposure and particular characteristics of the underlying assets and overall strength of the institution’s balance sheet. Banks can mitigate this risk by raising capital and ensuring adequate liquidity, and many banks are considering this option now.

Alternatively, banks could shift assets from available-for-sale to held-to-maturity. The Federal Reserve’s November Beige Book indicated that some institutions are taking this step. This approach allows banks to avoid reporting the value of the assets in the current market but brings about two new challenges. Banks would have to fund the assets to maturity (at unfavorable rates for funding which may be higher than the return), and they would have to hold the assets to maturity, at a huge opportunity cost. The assets may continue to perform in accordance with the original contractual terms, but that yield would lag below market rates.

The OCC is not alone in paying careful attention to interest rate risk given the current risk of recession and market conditions. The Federal Deposit Insurance Corporation (FDIC) Chair Martin Gruenberg said he expects unrealized losses at banks to be an “ongoing challenge” for banks at an oversight hearing before the House Financial Services Committee in November and reiterated this concern at a nomination hearing two weeks later. With his focus on the solvency of banks and the deposit insurance fund, such warnings should be heeded by the industry and watched closely by investors.

Further, Board of Governors of the Federal Reserve (FRB) Vice Chair for Supervision Michael Barr also expressed concern that during the 2008 global financial crisis, bank regulatory capital levels “did not reflect future losses that would severely weaken their capital positions. And banks lacked appropriate controls and systems to measure and manage their risks.” Barr is currently conducting a review of the FRB’s capital standards.

Compounding Effects and Considerations for Banks 

While declining asset quality because of rising interest rates and economic factors hurts investment portfolios and can strain liquidity, two separate factors can compound those effect on bank portfolios that banks should consider in their comprehensive risk management strategies.

The first factor involves a term often heard in the halls of the OCC—“knock on” effects. In an increasingly interconnected financial ecosystem, the risks embedded in customer and partner portfolios need to be considered carefully, particularly if a bank has potential concentrations in certain markets or regions that would be hit harder by continued economic challenges and market transitions. Bank asset quality can deteriorate quickly in such circumstances, which simultaneously may be the most difficult times to raise capital and liquidity.

The second factor involves the accounting standards associated with the Current Expected Credit Loss accounting standard, or CECL, which was implemented over the past several years.

Prior to CECL, firms relied on historical loss rates to calculate the allowance for loan and lease losses (ALLL). This approach worked poorly in the last crisis, and CECL was developed to estimate the expected loss over the life of a loan. There are three important aspects of CECL:

1. CECL requires institutions to consider forward-looking information when estimating credit losses. Prior to CECL, institutions could only consider loan losses incurred as of the balance sheet date.
2. CECL requires companies to group investment securities by common risk characteristics.
3. CECL continues to require companies to consistently report losses so partners, like auditors, can stress test. That reporting includes monitoring and revalidation based on the company-specific and overall market factors.

While implementation of CECL occurred in phases, CECL will apply to all banks at the beginning of 2023.

The full effect of CECL on balance sheets remain to be seen. How accurately models created just a couple of years ago perform today and how much will companies need to adjust them based on current expectations could result in much larger ALLL requirements further impairing balance sheets. That affects banks and their customers, potentially creating a “trickle up” effect on risk.

Regulators will be watching banks closely over the next several months as indicated by the recent OCC report and FRB pronouncements. Banks should work to get a head of regulatory concerns and ensure their safe and sound operations by conducting thorough review of their asset quality and potential exposure to their portfolio, partners, and customers. Bank directors should ask management clear questions about the quality of allowances for credit losses, liquidity and contingency plans. Management should update governance and risk appetite policies in light of current market conditions and strategic plans.

Put Patomak’s Banking Expertise to Work

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Links

• OCC Semiannual Risk Perspective (December 2022)
• Fed Beige Book (November 2022)
• Speech by Fed Vice Chair Michael Barr: Why Bank Capital Matters (December 2022)
• Remarks by FDIC Acting Chair Martin Gruenberg before the House Financial Services Committee (November 16, 2022)