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Who's afraid of rising interest rates? Banks!

By David Ellis, staff writer

NEW YORK (CNNMoney.com) -- Of all the things keeping bankers up at night these days, the direction of interest rates may soon rank up there with loan losses and the heavy hand of the government.

For more than a year now, the Federal Reserve has kept the closely-watched federal funds rate between 0% and 0.25% in an effort to help jumpstart the U.S. economy.

Lenders have benefited handsomely as a result, borrowing money cheaply and making long-term loans with healthy profit margins. But expectations are growing that the nation's central bank will soon reverse its loose monetary policy stance in an effort to tamp down the threat of inflation.

And that has banking regulators worried.

Earlier this month, the Federal Deposit Insurance Corporation and other bank regulators, issued a stern warning to lenders about interest-rate risk, telling banks to take precautions in case the central bank decides to hike rates dramatically.

"Regulators have a great deal of concern that this will be the next shoe to drop," said Bob Morgan, partner at Austin Associates, an Ohio-based boutique investment bank and advisory firm that caters to the community banking industry.

The reason a swift and sharp increase in interest rates could be troubling, according to experts, is because banks have gotten used to paying low rates for deposits and charging significantly higher rates for loans.

During the first nine months of 2009, the nation's banking industry earned $298.3 billion from taking in deposits and lending them back out, $19 billion more than the same period in 2008, according to the most recent data published by the FDIC.

A sudden rate hike would mean banks would have to pay more for deposits, while rates on many of their existing loans would not increase in tandem, resulting in slimmer profits or perhaps even losses for some institutions.

Since the industry is still grappling with record losses on many consumer and real estate-related loans, higher rates could make their problems worse.

An inability to adapt to a sudden change in interest rates is hardly a new problem for the industry. Hundreds of institutions went under during the savings and loan crisis two decades ago largely because of rapidly rising interest rates.

During that period, more than 1,900 financial institutions were shuttered, including more than 500 in 1989.

Despite the similarities to that painful period, it seems unlikely that just as many lenders are at risk this time around.

New regulations and exotic hedging instruments like interest-rate swaps that were developed in the years following the savings and loan crisis have helped better insulate lenders during subsequent rising interest-rate environments.

At the same time though, many banks, particularly small lenders, could find themselves a lot more exposed to rate hikes than they had originally hoped as the market for some of these products, like interest rate swaps, remain dormant.

"Over the last 10 years, lots of instruments were created to help banks manage this risk," said Morgan. "Of course, those markets have disappeared."

While big banks like JPMorgan Chase (JPM, Fortune 500) and Bank of America (BAC, Fortune 500) have a significantly larger arsenal of other rate-hedging tools at their disposal, smaller, less sophisticated institutions may have to embrace more tried-and-true methods.

That could include more attractive rates to consumers on long-term products like 5-year certificates of deposits or shorter-term loans, said Chris Cole, a vice-president and senior regulatory counsel for the Independent Community Bankers of America.

Ideally though, banks are hoping that the Fed raises rates at a gradual pace, which would still allow them to enjoy the same kind of returns they have over the past year.

That is possible. Other than the dramatic rate cuts during the height of the financial crisis in 2008, the Fed's moves have been rather predictable in recent years.

Traders and bankers are not expecting any significant moves in the next few months.

According to fed funds futures listed on the Chicago Board of Trade, investors aren't betting on a rate hike until later this summer. Economists for the American Bankers Association said earlier this month they think the Fed will only raise rates by three-quarters of a percentage point by year's end.

But if recent history is any indicator, things are hardly predictable within the economy, especially when it comes to interest rates.

"Sometimes the Fed can't control how quickly rates go up," said Cole. To top of page

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