November 2, 2017

Interest Rate Risk: Banks Sacrifice Yield in Exchange for Greater Control

Banks are placing more of their investments into short-term instruments in order to manage interest rate and market risk. 

Remember the Great Recession of 2008-2009? Interest rates plunged to all time lows and banks were pressured and looking to get all the yield they could get in high quality assets.  Many turned to longer duration assets.

While the Fed has signaled intent to raise rates...

Managing Interest Rate Risk Is What Banks Are Looking at Now

Now, those days are decisively over in many ways, and none more so than for banks. Rather than looking for yield, many banks are, in the words of American Banker, “sacrificing yield” so that they have more leeway in managing the potential risk of rising interest rates.

The United States Federal Reserve Open Market Committee has signaled that it intends to hike short-term rates. It’s already done some of this during 2017, and indicated intent to keep doing so in 2018.

But those signals are also clouded by other considerations that affect the Fed, such as the actual state of the economy, President Trump’s tax proposal and its fate, and policy proclamations and effects in the nation’s capital. A strengthening economy makes rate increases more likely, but evidence of any sputter can move hikes out further into the future.

It’s not even clear who will follow Janet Yellen as Fed chair; this is an important consideration because the Fed chair can make a difference in the rate and pace of any hikes in the Fed funds rate.

...policy direction in Washington, D.C. isn't clear.

Placing Investments into Short-Term Instruments

Ben Eskierka, the chief investment officer of Bloomington, Minnesota-based United Bankers' Bank, which is a portfolio management advisor, told American Banker that the flattening yield curve allows smaller and midsized banks to put their portfolios in shorter-term instruments without sacrificing too much yield.

During the third quarter, for example, Little Rock-based Bank of the Ozarks, with $20 billion in assets, purchased roughly $728 million of short-term mortgage-backed securities. The purchase is expected to lower Bank of the Ozarks’ average yield, as they yield roughly 2%. But, as the chief financial officer pointed out when discussing the bank’s earnings, it is a useful tool for managing liquidity and eschewing interest rate risk.

Nonetheless, it may be a delicate balancing act. As American Banker notes, the Fed has a plan to unwind its balance sheet, which currently stands at $4.5 trillion. That might exert pressure on the entire system’s liquidity. If so, banks will need to hike their deposit rates to attract customers. 

Deposit rates have been low for quite a while, even as interest rates have risen, because banks currently have more deposits than loans, so their balance sheets are in equilibrium. If that changes, it could be worrisome.

Benefits of a Seasoned Loan Sale Advisor

Banks are placing more of their securities portfolios into short term assets. A prudent move might be to place more of their loan portfolios into short-term investments as well. Banks can buy short duration, high quality assets with a higher yield than securities. A seasoned loan sale advisor can help guide the way in a changing interest-rate environment.

To see how experienced loan sale advisors can help, browse the Garnet Capital white papers.