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Interest Rate Risk: Lessons from the Past Raise Concerns for the Future

Posted by Ryan Zagone, Lead Market Insights Analyst, Banking & Securities, Deloitte Services LP, on April 2, 2014

Between 2004 and 2007, a strange thing happened to banks' interest margins. One group saw its net interest margin remain essentially unchanged. But another group saw a steep and painful decline in its interest margin, falling over forty basis points.1

The Federal Reserve raised the federal funds rate by 425 basis points during this period, yet one factor determined in which group a bank would belong: its concentration in long-term assets.

Considering banks with under $1 billion in assets, those with less than 30 percent of their portfolios in long-term assets experienced only a two basis point reduction in net interest margins from 2Q 2004 to 1Q 2007. But those that had allocated over half of their portfolios to long-term assets saw a 43 basis point reduction in interest margins.

As shown in Table 1, the greater the long-term asset concentration, the greater the interest margin compression.

Table 1. The impact of rising interest rates on banks under $1 billion in assets

Banks' percent of assets that are long-term* Change in NIM from 2Q04 to 1Q07
Less than 30 percent -2 bps
30-40 percent -16 bps
40-50 percent -32 bps
Greater than 50 percent -43 bps

*Long-term assets are those which reprice or mature over five years from the reporting period. Source: FDIC analysis.

If these conditions sound familiar, it's because they should. The United States is likely heading for a period of rising interest rates and without appropriate attention, some banks may be positioned for a similar margin pinch as described above.

Such problems could come at a bad time. After facing many headwinds over the past several years, banks have adjusted enough to report four consecutive years of net income growth, even though net interest margins remain compressed.2 One major contributor to the improvement has been banks' ability to recapture reserves initially set aside for bad loans.

But further, as an FDIC briefing for bank board members puts it, banks are repeating past cycles by attempting "to combat declining margins with investments in higher yielding, long-term assets."3

Long-term assets are loans and securities that pay higher yields to compensate for the fact that they do not reprice or mature for over five years.

The data clearly illustrates this trend: long-term assets have risen 53 percent from 2006 through 2013, while total assets grew only 24 percent over this period.

Due to this growth, long-term assets made up 25 percent of the industry's total assets in 2013, up from 20 percent in 2006. The chart below shows the median long-term asset concentration by bank size. While using medians and grouping banks by these asset classes does make concentration levels appear higher than the industry aggregate of 25 percent, it does clearly illustrate the increase in concentrations.

This increase is particularly evident in banks with assets between $1 billion and $10 billion: long-term asset concentrations in this group rose from 18 percent in 2006 to 34.5 percent in 2013.

Source: SNL data, Deloitte analysis

Investing in such assets may help support earnings today but may also create challenges in the future.

As interest rates rise, a bank's cost of funds could rise faster than the yield of its assets if it has not sufficiently prepared or hedged for such conditions. Margins may get squeezed, unrealized losses may mount and interest-sensitive revenue may be jeopardized.

The pressures to deploy excess liquidity, support margins and grow profits are undeniable; yet, taking on large concentrations of long-term assets may be only a temporary fix, one that could backfire.

Considering that 17 percent of the industry — over 800 banks — had at least half of their portfolios in long-term assets at the end of 2013, this may be an opportune time for boards and management to reassess their interest rate risk positions, ensure they have prudent risk tolerances in place and define clear lines of authority and internal controls to address interest rate risk in the coming years.

Taking time to review and prepare today can help avoid the same pain some firms felt in the past cycle.

1 FDIC Virtual Directors' College Program: Interest Rate Risk,
2 FDIC Quarterly Banking Profile, 4Q 2013,
FDIC Virtual Directors' College Program: Interest Rate Risk,

As used in this document, "Deloitte" means Deloitte LLP and its subsidiaries. Please see for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.

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