Think Rates Are Going Up? Banks Dont

Rachel Louise Ensign, "Think Rates Are Going Up? Banks Don’t,"Wall Street Journal, August 22, 2017, https://www.wsj.com/articles/think-rates-are-going-up-banks-dont-1503419152

Think Rates Are Going Up? Banks Don’t

The percentage of bank assets that won’t mature or change rates for more than five years reached a new high in the second quarter, according to Federal Deposit Insurance Corp data released Tuesday. That means banks are allowing more borrowers to lock in low rates for long periods, a potential risk should rates move sharply higher.

“The interest-rate environment and competitive lending conditions continue to pose challenges for many institutions. Some banks have responded to this environment by ’reaching for yield’ through higher-risk and longer-term assets,” FDIC Chairman Martin Gruenberg said in remarks accompanying the data.

Banks largely make money in two ways: from lending and fees. Midsize and smaller lenders tend to rely more on lending profits than bigger banks that have fee businesses like wealth management. Lending profits typically come from the difference between what banks pay out on deposits and what they earn on loans and securities.

But rock-bottom interest rates following the financial crisis eroded those margins across the industry, leading some banks to lend for longer so they can capture more yield. Growing their volume of loans also helped them compensate.

“It’s a struggle for everybody in the industry,” said Denny Hudson, chief executive of Stuart, Fla.-based Seacoast Banking Corp. of Florida, which has $5.3 billion in assets. He said his firm tried to keep its lending in check, but added there is a downside to being too careful.

“You could be smart all day long waiting for rates to increase, and you’ll get killed by investors” rooting for loan growth, Mr. Hudson said.

Regulators and bank investors typically worry about interest-rate risk because banks borrow money at low rates on a short-term basis, usually by taking deposits, and lend it out at higher rates for a longer term. That can create a mismatch if rates move sharply higher.

An added worry: much of this lending for longer is in the booming area of commercial real estate, where borrowers finance offices and apartment buildings typically with loans that have fixed-rate periods from three to 10 years.

“Every meeting I went to, bankers said, ‘We’re not going to go past five years” on commercial real estate, said Scott Hildenbrand, chief balance sheet strategist at Sandler O’Neill + Partners. Within a year or so, the bankers were saying, ‘We’re not going to go past 10 years.”

Englewood Cliffs, N.J.-based ConnectOne Bancorp, Inc., for instance, has grown quickly in recent years largely through commercial real estate lending. These loans made up more than half of the bank’s assets at the end of 2016 and most of them were originated in the past three years, the bank said.

Competition for such borrowers was fierce, though it has slowed a bit in recent months after regulators raised concerns about the sector broadly, Chief Executive Frank Sorrentino said in an interview. While Mr. Sorrentino said his bank, which has $4.7 billion in assets, has expertise in the sector that serves it well, his firm has recently started to diversify lending.

“There’s risk in everything that we do,” Mr. Sorrentino said of banking. “That’s what we do, take credit risk and interest-rate risk.”

Across all banks, the percentage of total assets that are at a fixed rate for more than five years was 27.5% in the second quarter of 2017, its highest since the FDIC started tracking it in 1984. The metric reached 33.7% in the second quarter at banks with $1 billion to $10 billion in assets.

Commercial real-estate loans made up 31.5% of assets at those midsize and smaller banks in the quarter, up from 25.7% in the second quarter of 2012. The figure is far lower at bigger banks, at 6.4%, and has remained steady in recent years.

So far, the reach for yield hasn’t proven a problem as long-term rates have remained low, despite the Federal Reserve increasing short-term rates. The yield on the benchmark U.S. 10-year Treasury has been around 2.20% of late and hasn’t touched the 3% mark since early 2014. At the same time, credit quality of loans has stayed strong.

Indeed, the FDIC said in its report Tuesday that U.S. banks’ earnings rose 10.7% to $48.3 billion in the second quarter from a year earlier, indicating the sector is continuing its postcrisis recovery. Nearly two-thirds of banks reported their earnings were up from a year earlier.

The FDIC cautioned that the pace of loan growth is waning. U.S. banks had about $9.4 trillion in net loans and leases in the second quarter. While that was up 4% from a year earlier, the rate of growth is down from a 7% pace in much of 2016.

Problem loans also continued to decline, with banks reporting a 6.7% decrease in loans that were 90 days or more past due in the second quarter compared with a year earlier.

Still, regulators have warned that the growing share of longer-term and commercial-real estate loans at some banks could be risky.

By locking in longer terms for loans at lower rates, banks could face a profit squeeze if they have to raise deposit rates sharply in the future. And a heavy concentration in commercial real-estate loans could become an issue if credit issues begin to crop up.

Between 2015 and early 2017, commercial real-estate loans generally grew at a pace above a 10% annual rate at smaller lenders, according to Federal Reserve data.

“This was generally what they knew and knew well,” Christopher McGratty, an analyst at Keefe, Bruyette & Woods, said of commercial real-estate lending at smaller banks. Lending to businesses, for instance, often requires more specialized knowledge, which gives larger, more-diversified banks an advantage.

The growth rate for commercial real-estate loans, now around 9%, has helped banks compensate for a slowdown in general business lending, much of which is floating rate, meaning the interest rates on the loans rise and fall with market rates.