I sometimes play around on FRED, where I put together charts that take a lot of the macro data I consume, transform it into more significant permutations, and visually illustrate the results. Last night, I took a dive into commercial bank balance sheet compositions, in aggregate, to get a sense for the health of–more specifically the risks embedded in–the US financial system.
In terms of credit risk (i.e. exposure to loan losses), the data say that banks are well insulated–if from nothing else, because lending has been meagre. As the following chart shows, total loans/total assets (46%) is at 30 year lows. Deposits are adequately reserved against, with the reserve rate ratio at a conservative 19.25%. Separately, I looked at loan loss reserves/total loans (2.1% as of 1q13), which ratio is slightly above the historic mean–albeit falling fast. In the place of loans, it appears that the growth of bank assets since 2008/9 has come from the accumulation of Treasury & Agency securities, which are up to 14% of total assets:
While exposure to credit risk/default risk may be low, I worry that banks’ interest rate risk is conversely a significant threat. There appears to be a material asset/liability duration mismatch. For example, in aggregate, the above chart says that commercial banks are 79% capitalized by deposits, a 30 year high. Banks adjust deposits’ interest rates to compete with other institutions in attracting customers; other sources of capital, like debt and equity, have fixed rates–with the exception of step-up notes or floaters, a minority of the capital stack, for which rate risk banks usually hedge upon issuance. Thus, if interest rates rise, banks’ aggregate cost of capital will rise (due to ~80% of liabilities in deposits), and the value of their fixed rate assets will fall (14% of total assets are government securities alone).
The following chart illustrates the latter point, namely bank assets’ current yield is razor-thin, as manifest by net interest margins of 3.21%, a low bested only by the 3.15% in 3q08. Further, origination volumes have been strong despite the low rates, meaning that more loan assets are being issued with these low yields:
To determine whether or not commercial banks have been managing this exposure, we can look at interest rate swap markets, which I’ve mentioned previously (I, II, III) as a critical indicator for the orderliness of the unwind from this 30+ year disinflationary environment. At first glance, the swaps market seems to have reacted with appropriate correlation to the undulations in underlying interest rates. However, the magnitude of swap spreads’ reaction seems too tepid–as if to say that demand declines with every pass higher in rates. For example, this chart shows 5y swap spreads vs 5y Treasury yield ($FVX). You can see that FVX has reached today’s [relatively lofty] level on three other occasions since 2011, yet swap spreads have tightened on each successive occurrence, which tells me that commercial demand for rate hedging is soft.¹ By extension of that, I infer that banks are either unprepared for rising rates, or they simply don’t believe it’s time yet:
Banks’ gambit will either pay off, or it won’t. Only time can tell. Regardless, I have to acknowledge the apparent systemic exposure to interest rate risk. A lot goes into this stew. Like I’ve said before, the realized risk of rising rates depends on a lot of factors, like the composition of assets (fixed vs floating interest rates), convexity, and the velocity of rising interest rates. What I can determine from the above is that a significant implied risk is embedded within the banking system’s [apparently] poor asset/liability duration management. By any stretch of my imagination, a garden-variety rate tightening should principally inhibit the net income of banks at large, as opposed to their balance sheets/solvency.
¹Swap spreads can also tighten due to lower perceived credit/counterparty risk in the LIBOR component, but given widening spreads in credit markets ($LQD and $HYG), this factor seems to argue for even wider swap spreads.