Banks Are Facing Tough Questions about Interest Rate Risk from Regulators

Banks Are Facing Tough Questions about Interest Rate Risk from Regulators

You know that feeling you experience when something is obvious in hindsight? The subprime mortgage crisis of last decade, for example, seems inevitable in retrospect. Yet only a few were visionary enough to recognize the warning signs and act.

Today we’re seeing a similar scenario playing out with regard to interest rate risk — though admittedly on a lesser scale. Ten years ago, many smart people believed the housing prices would simply rise forever. A perfect storm of ridiculously lax lending standards, exotic financial instruments and about a dozen other factors ended that dream. Up until November, many equally smart people lived in a similar bubble in terms of interest rate risk. After years of rock bottom rates and an historic bull market, why make any changes?

The answer: Because bubbles never last, and this one was no different. Since the Presidential election, rising rates have caused the global bond market to lose a staggering two trillion dollars.

So what can be done to help banks, credit unions and other organizations deal with the fallout (regulatory and otherwise) from these losses? And how can we ensure such costly complacency doesn’t set in again?

I have an answer to both questions — and the solution might appear obvious once you hear it.

Those who fail to learn from history….

We’ve discussed how the delusional belief in ever-escalating housing prices was driven in part by years of sustained success. Who wants to rain on a parade, right? Fixed-income investors have shared much of the same hubris thanks to our persistent bull market, which has made a genius out of virtually anyone with a pulse and a portfolio. The need for better technology to guide the investment process has been obscured by success.

Now, however, the $2 trillion bill has come due — and that’s left banks and regulators in a tough spot. Banks have gone longer and longer in an effort to maximize return. That was fine when rates were low, but, in this case, what goes down must come up — and that’s a hard truth too many organizations have avoided confronting.

Now, with losses piling up, regulators rightfully want to know how banks are controlling interest rate risk — the FDIC, in fact, last summer had organized educational outreach semimars including breakout sessions on this very topic. When losses accrue and reserves go down, thin margins will create a lot of stress on a financial institution, which ultimately stunts growth.

So what’s the answer? If we look at the classic attributes of a good investor, we see three things: she’s well-informed, she knows her risks and she’s disciplined. Unfortunately, many financial institutions don’t have the tools to really exhibit such characteristics.

Why? One key reason is a lack of transparency. Some brokers make huge commissions by finding banks and credit unions willing to buy high-commission products. If broker sells $2 million worth of a 20-year municipal bond, the broker might get a point or point and a half — essentially a $20,000 to $30,000 commission. These banks and credit unions often don’t have the tools,expertise,  or internal controls to discern the risks involved with such investments. Additionally, the pricing isn’t transparent, so it’s difficult to discern how much money is being spent on fees.

So what’s the solution?

For the last decade, we have training thousands of CFO’s, Treasurers, and institutional fixed income investors through books, seminars, accreditation programs, videos and one on one consulting.   While becoming the top thought leader in fixed income investing we were often asked about tools for fixed income pricing, market data, analytics and reporting.   The biggest problem we discovered was that the current market place offered tools that were complicated, expensive, and designed more for the seller and not the buyer.

Over the past several years our company, PFITR, has developed a few new technologies, one is called the Bond Price Valuation (BPV®) Tool.   It’s an affordable, online tool that provides transparent pricing and real-time portfolio data. It offers a window into the “true price” of an investment — like the Kelley Blue Book-style value you’ll find in the auto industry. This is enormously useful data; unlike stock prices, you can’t simply use Google for true bond pricing.

The Bond Price Valuation Tool can also clearly document (and create an audit trail) for investments that have been evaluated for interest rate risk and other variables. It also allows you to look at pricing history to mitigate the risk of buying at the wrong time. There’s always somebody selling high to a willing buyer — and a lot of time those willing buyers are banks.

Over the summer, I showed our product to several bank CFO’s, CEO’s, and investment professionals. Most CFO ‘s would ask “have you talked to the regulators?”  The question was so relevant because regulators were asking banks about how they were addressing this potential problem.  If you take five minutes to use the tool after a broker makes an investment recommendation, you have the perspective and ability to see what the market is doing.

Here’s the bottom line: There is still a lot of pain in the way of falling valuations coming to banks, Credit Unions and other institutional investors that have gone long chasing yield.   The regulators, in turn, will have some pointed questions for financial institutions that failed to deal with questions of interest rate risk.

By adopting technology like the Bond Price Valuation Tool, banks and credit unions will have the right answer to those tough questions.

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