The Next Test For The Banking System

 |  Includes: IEF, IYF
by: John M. Mason

I have been one that has been consistently concerned about the health of the banking system in the United States, especially the community banking component of it. My latest expression of concern occurred only last week. I wrote another post expressing concern the week before.

Now, Gillian Tett of the Financial Times has written about another rising concern about the community banking sector. The concern this time is about the increase in the yield on longer-term securities, especially on longer-term U.S. Treasury notes and bonds.

We know that the exceedingly low short-term interest rates have hurt the commercial banking industry because it has resulted in a squeeze on banks' net interest margin. In fact, a part of my second referenced post raises concerns about the squeeze on interest margins in the commercial banking industry, a point that Gretchen Morgenson highlights in her recent article in the New York Times.

Commercial banks would like higher interest rates because as interest rates rise and the yield curve takes on a more positive slope, net interest margins should increase and provided commercial banks with some breathing room. However, as Ms. Tett points out, there is a catch in this scenario.

She writes, "Precisely because of that margin collapse, many banks have quietly been adopting novel - if not desperate - strategies to boost earnings. Some have been extending more long-term loans, often at fixed rates, or investing in risky bonds or complex structured products."

And, now as the yields on these longer-term bonds rise in the market place, the market value of the bonds on the balance sheets' of these banks are falling.

Ms. Tett continues, "For the moment, at least, most regulators appear to think, or hope, that the largest U.S. banks are fairly well protected against that risk. That is partly because large banks have rebuilt their capital reserves since 2008, but also because many have engaged in sophisticated hedging strategies."

That leaves the "less-than-large" commercial banks.

In addition to moving into marketable securities with longer-term maturities, Ms. Tett writes, "banks have extended more long-term mortgage and commercial loans, often at low(ish) fixed rates. But another issue is a growing use of short-term debt and non-maturity deposits; in the past couple of years some $1,500 bn has moved from money market funds to bank deposits, due to those low rates."

"The net result of this, as the FDIC says, is that "the current structure of bank balance sheets suggests greater sensitivity to higher rates" than in 2004, or the last time that interest rates started rising sharply. Back in 2004, long-term assets were just 17 per cent of banks' portfolios; now they are 28 per cent. Similarly, in 2004 non-maturity deposits were 48 per cent; now they stand at 59 per cent."

But, Ms Tett quickly adds, "Of course, for the moment, these risks and costs are merely hypothetical; the Fed insists that it wants to keep rates low for some time."

The problem with this is that whereas the Federal Reserve may be able to keep short-term interest rates, especially its target, the Federal Funds rate, low for a long period of time, it may not be able to successfully keep longer-term interest rates low for the same time horizon.

In fact, I have argued recently (see "U.S. Treasury Bond Yields: Are International Investors Crossing into New Territory" and "Treasury TIPS Break Out: Is This the Move?") that the recent rise in U.S. Treasury yields has been because of an international movement of funds from "safe haven" investments, like U.S. Treasury securities, back into European sovereign debt.

This movement of funds has taken the yield on 10-year TIPS from a negative eighty or ninety basis points to a positive yield of about ten basis points. And, the yield on the regular 10-year Treasury bond has risen in parallel fashion to around the 210 basis points to 220 basis points level. Thus, the 10-year Treasury yield has risen between 50 and 60 basis points over the past five weeks or so, as Ms. Tett references in his article.

Many analysts have argued that this rise has occurred because Chairman Bernanke has hinted that the Federal Reserve may be near the end of its bond buying binge. On the other hand, I have argued that the movement of funds has taken place as international investors have become more confident that the financial markets in Europe have settled to the place that they can move back into the sovereign debt of the peripheral European nations and more safely earn a much higher return on their funds.

Over this past five weeks or so, the yield spreads in Europe have drastically dropped at the same time the yield on U.S. Treasury TIPS have risen. This to me represents a movement of funds from a "safe haven" to riskier debt and not just a concern that Mr. Bernanke and the Fed are going to slow down or stop the bond buying.

My own prediction has been that this movement of funds back into Europe will continue as long as international investors believe that things have settled on the continent. A consequence of this movement of funds will be that the yield on the 10-year Treasury security will climb back over 3.00 percent … and maybe then some.

It is also my contention that the Federal Reserve will not be able to contain this rise in longer-term interest rates. The Fed may be able to keep the Federal Funds rate down into 2014, but it will not be able to achieve the same success in the longer-term area.

Unless fears about the European sovereign debt market arise again -- and they might -- the yield on longer-term Treasuries are going to rise.

Now, back to the "less-than-large" commercial banks in the United States. I have argued for several years now that there is still a solvency problem in the commercial banking system. This is why the United States commercial banking system is shrinking by around 200 banks a year. Although commercial bank failures have dropped considerably, the FDIC and the Comptroller of the Currency are overseeing a substantial number of acquisitions that are accounting for the large decline in the number of banks in existence.

The issue that Ms. Tett brings to our attention is a very important one. People have argued that the Federal Reserve is not displeased to have the banking industry shrink in numbers. A rise in longer-term interest rates at this time would just contribute to that shrinkage, as Ms. Tett alludes to. Here we can point to another instance where Mr. Bernanke and the Fed are underwriting the wealthy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.