As Interest Rates Rise, Banks Face New Stress Tests

banks earnings interest rates stress test federal reserve
Justin Sullivan/Getty Images

By Stephen Gandel

Banks have mostly been tight-lipped about what rising interest rates would mean for their bottom lines. They will soon have to open up a little more to regulators and investors.

For the first time this year, the Federal Reserve is requiring nation's 18 largest banks to submit mid-year stress tests showing how they would perform if they were hit with a negative economic shock, like a spike in unemployment or interest rates. The results are due to the Fed on July 5. Unlike the bank stress tests conducted at the beginning of the year, though, the Fed won't run its own test, or publicly critique the results. Still, banks will be required to make the results public at the end of September.

On the eve of the submission, bankers are meeting with Fed officials next week in Boston at a closed-door symposium to discuss the stress tests. There has been some contention over the process in the past. Bank executives have expressed frustration that the Fed won't say how it gets its results. At a similar conference last year, Wells Fargo's (WFC) treasurer Paul Ackerman reportedly drew applause from bankers when he said he still didn't get how the Fed's loss estimates could be so different than his bank's.

Sponsored Links

On the list of topics for this year's meeting are residential loans, corporate loans and so-called counterparty credit risk, which is how much money one bank could lose if one of its trading partners goes bust. Putting a figure on that is one of the fuzziest parts of stress testing. In the past few months, regulators have stepped up scrutiny of corporate lending, questioning whether banks have made too many "covenant-light" and leverage loans.

But rising interest rates are sure to come up at the conference and in the mid-year stress tests. The yield on the 10-year Treasury bond has been rising recently, after being stuck near historic lows ever since the recession. The Fed included a sharp rise in interest rates as one of the shocks banks could face when it calculated potential trading losses in the stress test that were released in March. That was the first time the Fed had done that.

What's more, bankers say the Office of the Comptroller of the Currency has recently been questioning banks about interest rate risk. Last year, the OCC included rising interest rates in its report of top risks for banks.

It's hard to know how much banks would lose. Generally, banks have stuck to positives. Higher interest rates would allow the banks to charge more for loans. That could boost lending revenue and profits. But at the same time higher interest rates, and falling debt prices, have in the past caused big losses for the banks in their bond and loan portfolios. Banks have been less outspoken about that part of the rising interest rate story. But that might be changing.

Last week, at an investor conference, Bank of America's CFO Bruce Thompson indicated that the bank could lose as much as $11 billion in its bond and loan portfolio if interest rates were to rise 1 percent. He said that was as much as three times what Bank of America (BAC) would gain from higher rates in its lending business. But the bank might not have to realize those losses immediately, or ever if it holds the debt and borrowers end up paying. Still, the bank's capital could fall, which is something both investors and regulators have watched closely since the financial crisis, and something that would show up on the bank's stress test.

The best of times, worst of times story banks are telling about rising interest rates could end up being the other way around.

More from CNNMoney


Originally published