U.S. regulators on Thursday urged banks to protect themselves against hikes in interest rates, which could threaten the easy earnings that have helped heal the banking system during the credit crunch.
Banks have generated billions of dollars of profits by borrowing at low short-term rates and investing in higher-yielding long-term assets like Treasuries.
The statement from a group of regulatory bodies known as the Federal Financial Institutions Examination Council cautioned that rising rates could squeeze profits from that trade.
The statement implies that regulators are pressing banks to fix their balance sheets and get ready to stand on their own as the government and the Federal Reserve get ready to slowly reduce their extraordinary support for the banking system.
George Goncalves, head of fixed income rates strategy at Cantor Fitzgerald, said regulators are concerned that some institutions are expecting rates to remain at historic lows for a long time, a belief he considers to be delusional.
Just as banks thought they were properly hedged for credit and subprime prior to the credit crunch, many market players expect the Fed to keep emergency zero rates forever, Goncalves said.
Most analysts do not expect the Federal Reserve to raise interest rates until the second half of 2010, but many experts fear that history could repeat itself when the Fed does lift rates.
A series of interest rate hikes beginning in 2004 triggered events that ultimately created the credit crunch beginning in 2007.
The FFIEC said in a statement, If an institution determines that its core earnings and capital are insufficient to support its level of interest rate risk, it should take steps to mitigate its exposure, increase its capital, or both.
The FFIEC includes the Federal Reserve, the Federal Deposit Insurance Corp, the Office of the Comptroller of the Currency and the Office of Thrift Supervision.
The Fed cuts its benchmark federal funds rate to near zero in a series of rate cuts ending in December 2008. Over the last two years, the Fed has created a host of other emergency lending facilities to help fight the worst recession in more than 70 years.
But as interest rates start to climb from historic lows, banks relying heavily on short-term funds could see their funding costs accelerate.
Longer-term assets may no longer be profitable to own, forcing banks to sell securities en masse and potentially weakening the financial sector again.
The advisory said banks should have effective tools to manage their interest rate risk, including monitoring systems, stress testing and internal controls.
A top Federal Reserve policymaker said earlier on Thursday that the Fed should tighten policy sooner rather than later to contain longer-term inflation pressures.
Federal Reserve Bank of Kansas City President Thomas Hoenig told a conference that keeping short-term interest rates near zero could actually hurt the recovery process in financial markets.
With a low federal funds rate and a small spread between the discount rate and the rate paid on excess reserves, banks are more inclined to transact with the Fed instead of with each other, Hoenig said.
(Additional reporting by Kristina Cooke; Editing by Kenneth Barry)