We all remember the last recession as a very messy time in finance that was accompanied with an unseen number of bank and credit union failures since the Great Depression. We know the cause of that mess was poor credit quality. People were given loans which they could not repay, and when loans don’t get repaid, bank/CU capital gets depleted. If there isn’t enough capital, the institution gets shut down.
When most people hear of bank failure, they probably think the institution made too many bad loans, or, the institution became insolvent and ran out of cash to pay deposits. These are both certainly causes of bank failure, with insolvency being less of a concern in modern time. There is another unique way an institution can fail, which is the same manner in which any business can fail: the inability to operate profitably! In this case, the institution fails to make enough interest income to pay both deposit interest and overhead, such as salaries, utilities, etc.
When the spread between the interest earned on assets and interest paid on liabilities is susceptible to change, we say the institution is exposed to interest rate risk. The spread between those interest rates is how profit is earned, which pays for overhead and dividends. If that spread is too thin, an institution may fail due to lack of profitability.
Failure due to interest rate risk can occur in two primary ways. The first way is when the institution carries long-term deposits and borrowings, and uses those funds to finance short-term assets. When interest rates decline, the spread will be squeezed by short-term assets repricing to lower interest rates and long –term deposits remaining at their current levels.
Imagine taking in a 10-year deposit priced at 5.00% and using it to fund a home equity line of credit at 7.00%. In this case, the institution has a 2% spread (7% less 5%), which are profits used to pay overhead and dividends. Say the line of credit reprices monthly. Now assume in one year the interest rate on the line falls to 5.00%. That means now the spread is 0%. The deposit will remain fixed at 5.00%, despite the line of credit dropping to 5.00%. There is no spread now to pay overhead or dividends!
The other primary way interest rate risk causes failure is the complete opposite of the example above. Imagine you fund a 10-year fixed rate loan at 7.00% using deposits from a money market account that adjusts price monthly, and has a current interest rate of 5.00%. If short-term interest rates move up on the money market account, there will be less spread with the 10-year loan. If rates increase by more than 2.00%, there will be no more spread remaining, and the institution will be unprofitable.
As demonstrated, interest rate risk can be a problem when interest rates rise or when they fall. It all depends on how your institution structures its interest rates.
My present concern is I see banks and credit unions funding loans for long-term fixed rates of 10 years, 15 years, and even 20 years! The problem is they are not obtaining deposits or borrowings that also have a fixed rate for the equal period of time. This means these long-term fixed rate loans are being funded with short-term liabilities. If interest rates rise, their spread will quickly deteriorate. Also, take into consideration, interest rates persist at historical lows, which suggests they have nowhere to go but up.