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Bank Stress Tests and Rising Interest Rates
 

Bank Stress Tests and Rising Interest Rates

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Bank Stress Tests and Rising Interest RatesSince the financial crisis, the nation's largest banks have to undergo "Stress Tests" semiannually to see how they would perform in different economic scenarios including how the banks would perform if interest rates moved quickly higher in a short period of time. The Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act (DFA) stress tests were designed to help the Federal Reserve ensure that financial institutions have enough capital to withstand a shock to the financial system.

The first stress test this year was performed by the banks and are due on July 5. The results of the mid-year test will be interesting because interest rates on U.S. Treasuries moved considerably higher in the last 45 days. Banks generally do well when bank interest rates are rising. As mortgage rates and other loan rates move higher, the banks charge higher rates which earn the banks more money.

There also is a downside for banks when interest rates move higher. Banks have portfolios of bonds and loans. As interest rates rise, prices of these assets move lower. Granted, if banks hold these assets to maturity, they won't lose any money but if they have to sell these assets they sell them at a loss. A decline in the value of these assets also alters their balance sheet and their capital ratio, which shows up in the stress tests. Back in 2009 when the first bank stress test was performed, none of the banks failed but many banks had to increase their capital ratio.

Bank of America, JPMorgan Chase and Wells Fargo all indicated that they would lose billions of dollars in the loan and mortgage portfolios if Treasury yields increased by 1 percent or 2 percent. Bruce Thompson, Bank of America's CFO, said the bank could lose as much as $11 billion in its bond and loan portfolio if interest rates were to rise 1%.

Wells Fargo has indicated they could lose as much as $4.8 billion in their mortgage bond holdings. In JPMorgan Chase's 2013 Investor Day, the bank said it could see as much as $15 billion in losses if interest rates increase. The Federal Reserve's stress test in March for JPMorgan Chase show possible cumulative loan loss of $33.9 billion.

We will eventually see the final outcome of higher interest rates over the next year or two. The increase in rates could be rather quick because the Federal Reserve's key benchmark interest rate, the fed funds rate, has been in a range of zero percent to one quarter percent since December 2008. The Fed would have to increase the fed funds rate quickly just to get to a neutral stance where the rate isn't stimulating or restricting economic growth.

If inflation does pick up in the coming years and the Fed is behind the curve in raising the fed funds rate, we could see all interest rates move sharply higher in a short period of time. This is the exact same scenario that banks are facing in the current round of tests so the results could be a harbinger of things to come.

One of the benefits of higher interest rates would be higher CD rates, savings rates, and money market rates. This would be a godsend to millions of people who rely on interest income to live. Since the Fed lowered the fed funds rate to near zero percent deposit rates have also fallen to record lows.

Average 12 month certificate of deposit rates in the FDIC national rate survey are at a paltry 0.21 percent. Thankfully, there are 12 month bank CD rates many times the national average. The best CD rates in our database of 12 month certificate of deposit rates are just above 1.00 percent. If you're searching for rates be sure to check our rates at RatesORama.com.
Author: Brian McKay
June 17th, 2013