Banking

The Quest for Yield in a Low-Rate, High-Volatility Environment

August 2011 opened with a bang and has turned out to be a wild time in financial markets. The last-minute debt ceiling decision, Standard & Poor's credit downgrade of U.S. debt, and the Federal Reserve's decision to publicize its intent to keep short-term interest rates low into mid-2013 were some especially noteworthy events.

Extreme volatility in the financial markets occurred, with a sharp stock market correction followed by large daily stock market gyrations. In spite of the U.S. debt downgrade, U.S. Treasuries experienced a flight to quality, which increased prices (thus decreasing yields) as stock market volatility increased. Put another way, prices of the downgraded assets increased—a market reaction that took some participants by surprise. Just when it appeared rates could not go much lower, rates across the yield curve dropped. All of these events are happening against the backdrop of global economic concerns, especially in Europe, renewed fear over banking conditions, and talk of a double-dip recession. These are complex and challenging times for the markets and for financial institutions.

Earnings pressure and profitability challenges
Much of the focus over the last few years has been on deteriorating credit conditions and maintaining appropriate capital levels, which were high-priority risks facing financial institutions. During this period, interest rate risk took a secondary position as many banks struggled to survive while working through credit problems. As the industry is starting to see some positive trends in credit conditions, the strategic focus for institutions has shifted from survival to building capital and profitability over the longer term. Generally, deposit growth has been positive and loan demand weak, a development that places added pressure on profit margins. The historically low interest rates make it difficult to achieve attractive returns—especially when investing in high-quality, short-term products—so for banks there is a strong temptation to consider tactics to achieve better returns. As history and finance principles have proven, tactics that improve returns also add risk.

Risk and return: Interest rate risk implications
While interest rates overall have trended lower, long-term rates have remained high relative to short-term rates. Consequently, the shape of the yield curve is fairly steep (see the chart). The current environment has been characterized as a "low rate setup" where yield-chasing strategies tend to emerge. Under these conditions, banks may be tempted to engage in strategies to boost short-term yields by purchasing longer-term assets funded by shorter-term liabilities at a time when the riskiness of these strategies is increasing and the longer-term risk implications are more costly.

Net yields can be increased by purchasing assets with maturities further out on the curve, by purchasing assets with optionality such as callable or prepayable securities, or by increasing credit risk. Credit risk can be added in a number of ways, such as entering new markets or lowering underwriting standards to pick up additional interest spread.

An interagency advisory on interest rate risk, SR 10-1, dated January 11, 2010, highlights the need for active oversight and a comprehensive risk management process that effectively measures, monitors, and controls interest rate risk. SR 10-1 is especially relevant given the increase in the number of reported instances of yield-enhancing strategies such as the lengthening of duration in loan and investment portfolios, purchasing structured securities (which have complex embedded options), and seeking alternative loan products. Though offering higher promised returns, each of these strategies can elevate a firm's risk profile, and some strategies are more complex with additional risks that are difficult to quantify.

Some bankers have been approached recently by third parties promoting various yield-improvement strategies. One such strategy includes asset swaps where problem loans or other real-estate-owned properties are sold at par simultaneously with the purchase of high-yielding assets that pose significant credit risk. For any balance sheet strategy, banking supervisors expect a firm's management and board of directors to completely understand the full spectrum of risks a strategy may produce and how these risks may affect the firm.

All in all, expect the unexpected
If anything has been learned over the recent past, it is that markets are unpredictable and that events that seem unlikely can actually occur. Ill-considered long-term interest rate strategies and positions undertaken by an institution in a low-rate environment can be very costly to unwind and greatly limit a bank's flexibility to adjust its balance sheet. Banks and supervisors need to be aware of current yield-chasing tactics that pose undue risks and address those tactics now.

This article was written by John Kolb, an assistant vice president in the supervision and regulation department at the Atlanta Fed's Birmingham Branch.