Fitch Ratings in its report feels an increase in the interest rate would adversely impact bank’s capital under the proposed Basel III framework for U.S. banks.

Interest Rate

The recent increase in U.S. Treasury yields and speculation of Federal Reserve exiting bond buying program would accentuate potential risks faced by U.S. banks, according to Fitch Ratings.

Interest Rate Rise Would Affect Banks’ Bond Portfolio

U.S. banks are holding significantly large bank capital to conform to the proposed Basel III framework. U.S. banks’ unrealized gains on securities held in their balance sheets are at historically high levels. However, in the event of interest rates rising, this would affect bond prices, setting the stage for a reversal of unrealized gains. This would result in erosion of U.S. bank’s Tier 1 common capital levels.

The above erosion acquires significance for U.S. banks, as their investment portfolios consist of substantial mortgage bonds, on both absolute and proportional basis.

 Banks in the U.S. are expected to adopt the Basel III rules in the next few months, though the January deadline for adoption agreed to by banks across the globe has already expired.

Some of the U.S. banking giants have reported a marked improvement in their Basel III adjusted Tier 1 common capital ratios over the last few quarters.  Bank of America Corp (NYSE:BAC) and Citigroup Inc (NYSE:C) stand out in particular in this regard boasting of some of the strongest Basel III capital ratios among the global systemically important banks (G-SIBs).

Gradual Exit Would Have Less Significant Impact

Fitch Ratings feel if the Federal Reserve exit its bond buying program in a gradual and transparent way, the impact on bond prices for U.S. banks could be less significant. However, the sudden withdrawal would lead to losses potentially larger than on a percentage basis than those reported during the credit crisis.

The rating agency feels many of the Fitch-rated banks are asset-sensitive, their net income rising along with interest rates, as assets get repriced faster than liabilities. This acquires significance in the context of interest rates remained at historically low levels for considerably long period of time.

Fitch Ratings feel rising interest rates would put additional strain on banks having longer-duration balance sheets. Besides rising interest rates would deteriorate banks’ asset quality, cause cap rates to increase, leading to lower commercial real estate values.

More importantly, borrowers who were unable to lock in long term fixed rate funding will be forced with greater debt costs. This would potentially enhance default rates.

Fitch Ratings also warned that negative rating actions could emerge if the agency identifies banks not following risk management practices commensurate with their balance sheet strategies.