Up in Syracuse, N.Y., ONBANCorp Inc., a bank with assets of $2.5 billion, is making a ton of money in a rather unbanklike way. It borrows short-term money at 3%, then buys longer-term U.S. government and agency securities yielding 6.5% or more--and pockets the difference. The result: a bigger balance sheet and record profits.
"Our shareholders demand an adequate return on equity," says Randy J. Wiley, ONBANCorp's vice-president for investments and funds management. His bank is an active and profitable lender. But, he adds, "we did not have enough loan demand that we could grow the bank the normal way."
RATE RISE? Banks across the country are using the same strategy. In effect, they're lending to the government instead of to companies and individuals. And with the gap between longer-term rates and banks' short-term borrowing costs near an all-time peak, bank earnings are soaring.
But there's potentially a big catch: What if interest rates were to rise? That possibility is quite real, since the economy is showing signs of recovering at last. On Nov. 23, Robert B. Reich, who heads Bill Clinton's transition economic team, said the new Administration might be willing to increase the budget deficit for a brief term to stimulate the economy. The deficit is already running higher than expected.
Short-term rates have already been climbing. In late November, three-month Treasury bills were trading at 3.29%, up from 2.65% at the beginning of October. If that trend continues, banks' funding costs will rise, cutting into their profits from investing. And higher long-term rates would drive down prices on the securities that banks are holding.
The prospect of higher rates is worrying regulators and industry experts. Federal Reserve Board Chairman Alan Greenspan said in a Nov. 18 speech that while he is not seriously disturbed, "it is probably true that greater interest-rate risks have developed of late. . . . As regulators, we view both credit and interest rate risks as matters of concern." Henry Kaufman, president of Henry Kaufman & Co. and former chief economist at Salomon Brothers Inc., points to a more dire possibility: If higher rates erode banks' unrealized profits, banks will become even more cautious instead of expanding credit. "That would contribute to choking an economic expansion," he says.
Bankers tend to discount the risks. ONBANCorp's Wiley says he's keeping a close watch on his bank's investment portfolio so he won't get caught if rates rise. But he adds: "If banks are holding Treasuries for sale and not actively managing them, I'm sure some of them are licking their wounds as we speak."
Banks' move into securities and away from loans has been dramatic (chart). At the end of June, banks' investment portfolios stood at $734 billion, dwarfing their $546 billion in commercial and industrial loans. As of last June, more than 1,200 banks had at least 20% of their assets in investment securities with maturities of five years or more. Treasury securities accounted for most of the portfolio growth in 1991: Banks added $56 billion in T-notes and bonds to their investments, bringing their Treasury holdings to $229 billion, according to the Federal Deposit Insurance Corp.
Banks were lured into securities by weak loan demand and an aversion to lending to any but the safest customers. "We want to lend money. We've got money to lend," says Jack W. Parker, chief financial officer at Union Planters Corp. in Memphis. "We would like to have more loans and fewer Treasury securities," he says, but the bank isn't getting enough loan requests from creditworthy borrowers. Bankers also note that regulators require them to set aside $8 in capital for every $100 they lend to companies, but there is no such standard when they buy a Treasury security.
Regional banks have the greatest proportion of their assets in investment securities. Unlike big multinationals, they don't have a lot of other choices if local demand for credit is soft. "When you don't have the loan demand, there's only one place to put your money, and that's investments," says Tom Frost, chairman and chief executive officer of Cullen/Frost Bankers Inc. in San Antonio.
FAT CUSHION. Many bankers with large Treasury positions say they have hedged themselves against rate changes by buying swap or futures contracts. Others are looking for longer-term, fixed-rate funding for their securities positions, which sometimes have maturities of five years or more. Roughly three dozen banks have tapped the long-term debt market since the end of June. Still others have launched campaigns to get depositors to take out one- and two-year certificates of deposit.
Under current rules, however, regulators have few ways to check how well banks are hedging themselves. Examiners must rely heavily on their own interpretations of a bank's data to determine whether a bank is taking too much interest-rate risk, says Robert L. Inskeep Jr., director of large-bank supervision at the Office of the Comptroller of the Currency. In any case, hedging is no panacea. When banks hedge away their risk, they hedge away their fat profits as well.
Few observers expect bank failures even if rates spike upward. Many healthy banks, such as ONBANCorp, have a cushion of millions of dollars in unrealized gains on their investments. Moreover, government-securities markets are highly liquid, so banks could unload investments fast if necessary. And banks can often keep deposit rates down even after market rates rise. Three-month CD rates have actually dropped in the past two months, according to industry newsletter Bank Rate Monitor.
Richard D. Lodge, head of funds management at Banc One Corp., says higher short-term rates can even signal stronger business-loan demand, which would be good for banks. "You usually don't have high short-term rates associated with lousy economic growth," he notes.
But if rates do spike, many banks will have to wave goodbye to some of their easiest and most bountiful profits in years.