The flattening yield curve: after explaining the problem, as well as problems with its past management, the author tells bankers to listen to the Federal Reserve and the bond mavens when trying to deal with a flat and inverted yield curve. He also tells us what they're saying and provides nine rules to keep in mind

RMA Journal, The, May, 2006 by Tom Hannagan

Few banks have planned adequately for the flattening yield curve. Historically, the vast majority of banks have relied on three things: death, taxes, and a rising yield curve. The rising yield curve made it easy and attractive to borrow short and lend long. If most of the loans stayed current, this meant relatively automatic gross margins. With a dash of cost control, these margins lead, almost automatically, to acceptable earnings.

Banks typically have planned for fluctuations of 100 to 200 basis points in the yield curve. Some banks even run simulations of rate shocks, up or down, for moves of 100 or 200 basis points. These simulations provide some degree of preparedness for shifts in the level of interest rates--as much as 200 basis points. But very few banks simulate, let alone plan for, what actually has taken place--a 350-basispoint twist in the classic rising yield curve over the last 18 months. Twisting may be fun on the dance floor, but it's not fun to see how it negatively impacts a bank's financial statements.

Many banks have used a carry trade strategy by which they borrow short-term money (at relatively lower rates) and lend it over a longer term (at relatively higher rates). This strategy depends on our historically up-sloping yield curve. However, the yield curve is now flat and even a bit down-sloping.

Banks now are realizing that the carry trade strategy has severe problems. The embedded market risk in the carry trade is the likelihood that the cost of funding sources (deposits and borrowing) might increase more or faster than the interest income might increase from the funding uses (securities or loans). The carry trade, unhedged, contains many risks of this kind.

The largest banks were somewhat better prepared to restructure their balance sheets as these rises began to take place. They used sophisticated simulation tools to respond to these unusual twists. However, even they had disappointing results last year, which they blame on the degree and speed with which rates have twisted.

Approximately 8,000 smaller banks are dealing with these twists without the sophisticated tools used by the largest banks, and thus many have far worse results. There are two general categories of these banks: those that rely on relatively large securities portfolios and those that lend heavily to individuals and businesses.

Those that rely on large securities portfolios have been fortunate in one respect. Although they have seen their borrowing costs and interest-bearing deposit costs go up like everyone else's, they haven't had much increase in interest income and they haven't had the major write-downs that higher long-term rates eventually would have required.

Those that are lending heavily to individuals and businesses may have had the opportunity to automatically reprice the floating-rate portion of their loan portfolios and to reprice their shorter-term fixed-rate loans. Although they are likely to have more credit risk in the larger loan portfolios, in addition to the interest income inflexibility, some could have offset a bit of the known interest rate risk had they priced intelligently.

This flat/inverted yield curve has affected both sides of the balance sheet. Chronic margin pressures related to increased competition now are being exacerbated by the acute realities of the twisted yield curve. It is difficult to justify substantially higher intermediate-to-long-term fixed-rate loans, since long-term rate bases (treasury or Federal Home Loan Bank, for example) have not moved up nearly as much as the short rates.

Deposit rates, which tend to lag behind rising financial market rates, are now quickly catching up with the huge upward move in short rates. Just two years ago, with rates at historic lows, the economic profitability of demand deposits was in question. The very low interest rate costs of interest-bearing transaction accounts, along with their much lower operating costs, made these accounts more attractive than regular checking accounts. Now, demand deposit accounts (DDAs) are once again king of the hill. The banks with strong DDA balances have an advantage over banks that must rely on time deposits or external borrowing for funding sources. Even banks with strong DDA balance positions are reporting some runoff due to more attractive alternative short-term investment options.

So, what should banks do? The answer is amazingly simple:

* Always believe the Federal Reserve even when it's wrong or overly aggressive.

* Always believe the bond mavens, who are rarely wrong.

* Always take interest rate risk (as well as credit risk and other economic factors) into account when pricing loans and deposits-even if you end up pricing to the "competition" anyway-because at least then you'll know what you are doing, what you are giving up, and how you might try to offset the risk-adjusted suboptimal returns.

* Take action to adapt/adjust/ rotate your relative degree of rate sensitivity accordingly (with the emphasis on "action").