Some banks have been buying longer-term bonds to boost profits in a low-interest rate environment, sparking fears their profits will be squeezed when the Federal Reserve eventually starts to hike rates.
Banks are drawn to bonds maturing years in the future because the securities pay more interest than shorter-term debt. But rising rates will give banks higher funding costs, without necessarily giving the same lift to the income from all their assets, squeezing profits.
The lenders that could get hit hardest by higher rates are smaller community banks and mid-size regional lenders, analysts say. These banks generally have low income from fees and no real earnings from investment banking, relying mostly on income from lending and their growing bond portfolios.
Jeremy Stein, a member of the Federal Reserve's powerful board of governors, recently warned in a speech that low interest rates may have quietly contributed to banks taking more risk "below-the-radar."
"The added interest rate exposure may itself be a meaningful source of risk for the banking sector and should be monitored carefully, especially since existing capital regulation does not explicitly address interest rate risk," Stein said.
Bankers say they have few good choices when it comes to investing now, and are buying bonds because they need the income.
"Running a bond shop is not my favorite way to deploy assets," Commerce Bancshares Inc Chief Financial Officer Charles Kim said.
Since 2008, the Kansas City, Missouri-based bank's investment portfolio has surged by $5.9 billion, or 156 percent, to more than $9 billion, and the bank has been buying longer-dated bonds. Investment securities account for 44 percent of the bank's $22.2 billion in assets, compared with 22 percent in 2008.
"It is big. There is no denying that," Kim told analysts and investors last month during a banking conference in Boston.
That growth is greater than average, but overall many regional banks are moving in the same direction. Securities books for these banks grew 20 percent from 2010 to 2012, outpacing overall asset growth of 16 percent, according to a Reuters analysis of 80 mid-size regional banks, with assets between $5 billion and $40 billion.
With so many investors pouring money into bonds of all stripes, banks are not earning the returns on longer-dated securities that they would hope for even in the near term.
Last year, Commerce's interest income from investments fell $6.1 million, even as its portfolio expanded by nearly $1 billion, or 12 percent. The average rate earned on investments fell 38 basis points to 2.55 percent in 2012. The bank would rather make consumer and business loans, Commerce's Kim told Reuters.
Houston-based Prosperity Bancshares Inc has gone farther out on the yield curve than many of its peers to generate more income from its $7 billion-plus investment portfolio. Those investments account for 51 percent of Prosperity's $14.6 billion in assets.
The bank, which did not return messages seeking comment, disclosed in its annual report with regulators that in the first month after an interest rate increase, it would pay more to fund itself on $7.3 billion of deposits and debt. Although it would earn more on loans it made and on some bonds it owns, it only has $1.8 billion of loans and bonds that would benefit, according to its interest-rate risk analysis.
The $5.5 billion mismatch, one of the largest disclosed by a mid-size regional, could hurt the bank's profit if cheap deposits become more expensive while loans and bonds re-price and mature at slower speeds.
Even with this risk, analysts are bullish on the bank's acquisition strategy. Its stock is up 16 percent over the past 12 months, outperforming the 14 percent rise on the KBW Bank Index.
In more normal times, rising rates often help small and mid-sized banks. Rate hikes typically come when the economy is getting stronger, which also means that companies and consumers are more interested in borrowing money. And for the average community or regional bank, most of its assets carry floating rates, meaning that as rates rise, the bank earns more interest income. As long as the income banks get from their assets rises faster than the rates they have to pay on their deposits, banks have little to fear from rate hikes.
Banks report their sensitivity to rising rates in their financial statements posted with regulators, and generally mid-size regional banks say that rising rates will help them.
But analysts say there are reasons that may not be so this time around. Interest-rate shock tests performed by banks may not capture the changing dynamics of the marketplace and consumer behavior. Even banks acknowledge the limitations in their discussions about rate sensitivity, their regulatory filings show.
One example of how reality may differ from banks' expectations: as more consumers embrace web- and mobile- banking, depositors may become quicker to switch their money to a new bank when rates rise. To avoid losing deposits, banks may have to raise their rates faster than they have in the past, resulting in higher costs for banks, said Fred Cannon, director of research at Keefe Bruyette & Woods.
But low rates put pressure on banks too. Older fixed-rate loans that pay higher rates mature over time, leaving banks with more recent loans that pay lower rates. Banks that play it safe and avoid investing in longer-dated securities face pressure from investors who want stronger returns now, said Brad Milsaps, a bank analyst at boutique investment bank Sandler O'Neill.
"Their earnings are eroded if they decide to stay short," Milsaps said. "That's hurting them in this environment."
In the fourth quarter, 68 percent of all banks reported year-over-year declines in net interest margin, the difference between what banks pay on deposits and what they earn from loans and investments.
Commerce Bank CFO Kim said his bank has been battling against interest rates for several years.
"Between 2007 and 2008 we got a little help from rates," Kim said. "Other than that, rates have been against us for all this time, and it's only the volume that has allowed us to even keep things on an even keel."
The Fed is considering the risk of its inflating financial bubbles as it keeps rates low, and may curb its expansionary policies to avoid further inflating bubbles.
In the near term, banks have little to fear from rising rates. The Federal Reserve is buying $85 billion a month of mortgage-backed securities and Treasuries, and all 17 primary dealers, or banks that trade directly with the Fed, said they expect the purchases to continue until at least late this year, and 11 of the 17 expected them to persist into 2014.
(Reporting By Tim McLaughlin, Editing by Dan Wilchins and Tiffany Wu)