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Many investors think this bet on higher rates is a sure thing. It's not

Jeff Cox
Banks are making what could turn out to be an expensive bet that interest rates will stay low for several more years.

Banks are making what could turn out to be an expensive bet that interest rates will stay low for several more years.

The level of loans and securities with a duration of longer than three years is at 35.4 percent of total assets, according to data the FDIC released this week. That's near the highs reached late in 2016 and indicative to regulators that banks are taking risks that could backfire.

Those particular assets mostly have fixed rates. If interest rates rise over the next few years and banks have to pay more for deposits, that would crimp operating margins and cut into profits. While many industry watchers have touted the benefits of higher rates for banks, there's also a risky flip side.

"The interest-rate environment and competitive lending conditions continue to pose challenges for many institutions," FDIC Chairman Martin J. Gruenberg said in a statement. "Some banks have responded to this environment by reaching for yield through higher-risk and longer-term assets."

Banks are coming off another strongly profitable quarter, earning $48.3 billion in net profits in Q2 and posting a 1.14 percent return on assets that was the best since the second quarter of 2007, just before the worst days of the financial crisis.

However, the post-crisis days have posed a unique challenge for the $16.4 trillion industry. The Federal Reserve has kept benchmark rates anchored at historically low levels , sending institutions scrambling for ways to generate yield.


One way has been through locking in loans that promise steady if low returns. That's worked as the Fed has held to its accommodative policies and banks have paid paltry rates on savings.

However, the Fed has been raising rates slowly and officials have professed a commitment to continuing increases at least for the next several years. Should deposit rates rise as well, that will put the squeeze on those fixed rate bank loans.

"While the quarterly results were largely positive, the operating environment for banks remains challenging," Gruenberg added. "An extended period of low interest rates and an increasingly competitive lending environment have led some institutions to reach for yield. This has led to heightened exposure to interest-rate risk, liquidity risk, and credit risk."

Still, banks at this point appear to be in a strong position, at least by regulatory standards.

The industry came through this year's stress tests with few blemishes and some were allowed to return more than 100 percent of profits to shareholders through dividends and buybacks. The number of FDIC "problem banks" fell to 105 from 112 in the first quarter — and nearly 900 during the crisis. Also, the reserve coverage ratio, a measure of banks' ability to cover credit losses, is at its highest level since the third quarter of 2007.

But with a changing landscape ahead and banks' risk profiles growing, regulators say they'll be keeping a watchful eye.

"These risks must be managed prudently for the industry to continue to grow on a long-run, sustainable path," Gruenberg said. "We will continue to monitor closely the environment in which banks operate, and we will remain vigilant as we conduct our supervision of the industry."

WATCH: Rising rates aren't the only danger posed to big banks.