July 15 - A meaningful number of U.S. banks have seen loan portfolio durations extended, upping the interest rate risk that some banks would face if rates climb rapidly, according to Fitch Ratings. Record low interest rates have made it attractive for borrowers to seek lengthier loans, which even under a slowly rising rate environment, will be a headwind on net interest margins over the short and medium term.
Data compiled by Fitch on all FDIC-insured banks shows that loans dated longer than five years as a percentage of total loans have risen to 25% at the end of 1Q14, up from 18% at year-end 2008. The proportion of loans over five years has been steadily climbing since 2008, and currently is at its highest level since the FDIC began tracking such data in 1997, when the ratio was just 13%. We believe that long-dated loans could remain on an upward trend so long as borrowers seek to lock in longer-term financing and banks seek to show reasonable loan growth to various stakeholders.
Within Fitch's rated universe, community banks are consistently more concentrated in long duration loans, averaging roughly one-third of loans over five years in length as of the end of 1Q14, up just marginally from the end of 2008. This generally corresponds to industry data which shows that community banks (generally less than $10 billion) typically stretch relatively more than larger peers when it comes to length of loan duration as they compete for loan growth and tend to hold on to longer-dated residential mortgages.
Large and midtier regional banks have a lower proportion of longer-dated loans relative to community banks, but long loan growth as a proportion of total loans among regional banks has been more pronounced, as loans over five years have grown to 22% of total loans, up from approximately 16% in 2008. Multiple regional banks have communicated strategies to hold longer-term conforming mortgages, which can increase interest rate risk in a rising rate environment, depending on the mortgages' maturity and repricing characteristics. While retained conforming mortgages remain small, we have concerns about loan extension risk as rates rise.
Fitch also believes that increases in auto loans could be contributing to the rise in longer-dated loans on balance sheets. A recent report released by the Office of the Comptroller of the Currency points toward banks using longer terms on auto loans in order to attract demand.
Interest rate derivatives mitigate some rate risks, particularly for larger banks. Interest rate derivatives have been prominent at large regionals, comprising around 40% of total assets on a notional basis. Such hedging activity could blunt the impact of rate volatility on margins and asset values as rates rise. In contrast, Fitch's community bank peer group tends to utilize hedging strategies much less than larger peers with interest rate-related derivatives accounting for under 6% of total assets for the group.