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Fed Pushing Banks Back Into Risky Business: Moody's

NEW YORK ( TheStreet) -- Low interest rate policies promoted by the Federal Reserve, European Central Bank and other central banks around the world are a key issue for the banking sector as firms dial up their risk to boost earnings, according to ratings agency Moody's Investor Service.

Moody's highlights low rates as the second biggest risk for banks in 2013 because they undermine banks' profitability, create asset bubbles and could pressure C-Suites on Wall Street to take on too much risk by way of providing financing to clients and increasing risk tolerances in their securities portfolios.

The prospect that banks will overextend their balance sheets to finance merger and private equity deals -- and hold high yielding assets that may backfire -- is reminiscent of the days prior to the financial crisis. That's when the Fed's low rates propelled firms to finance debt-laden buyout deals of a seemingly ever increasing size. Meanwhile, a chase for yield spawned complex financial products that carried more risk than what firms had anticipated or could tolerate.

In fact, Moody's indicates such a scenario is already causing banks to return to some of their pre-crisis ways, even if products like collateralized debt obligations and subprime real estate securities that got banks in trouble remain in a thaw.

"The basic point certainly is increased risk taking," says Robard Williams, a Vice President at Moody's. "Risks can be clouded by low rates," adds Williams, who notes an increasing exposure to longer dated assets and ones with increasing credit risk in a rising interest rate environment.

In a report published on Thursday, Moody's highlights low interest rates as the second biggest lingering risk for the global banking system in 2013 - only surpassed by macroeconomic issues such as a weak global growth and continued economic stress in Europe.

"[Banks] have already begun to relax loan standards after they were tightened in response to the financial crisis," writes a team of Moody's analysts led by global banking managing director Gregory Bauer.

"This loosening will be further encouraged by greater risk appetite from the bond market, which the banks compete against in providing financing to their clients. Another threat is that banks take on greater credit or extension risk in their securities portfolios to achieve higher yields," the Moody's analysts add.

On a more fundamental level, low rates pressure the interest income and margins of America's largest banks. In fourth quarter earnings, falling yields caused interest margins to fall farther than expected for Wells Fargo (WFC - Get Report), the largest mortgage lender in America.

In the U.S., a third round of monetary easing by the Federal Reserve in September targets the mortgage market and has pushed 30-year Fannie Mae mortgage rates near all-time lows just above 3%. The Fed also expects yields to stay low well into 2015 and also after gross domestic product (GDP) growth starts to accelerate in the U.S.

Currently, the 10-year U.S. Treasury yields roughly 1.83%, up slightly from one-year lows of 1.38%. Ten-year government bond yields in Canada, the United Kingdom and Germany are all below 2%, and in Japan, yields stand at just 0.72%, up barely from 12-month lows of 0.684%.

When it comes to securities portfolios, Moody's notes that banks buying up higher risk and longer maturity assets may not fully see the risks of such investments until interest rates begin to rise.

Williams, the Moody's Vice President, says a scenario of falling net interest margins and rising credit costs on loan portfolios would indicate the negative impact of current Fed policies. "This is only going to begin to surface in coming years," he adds.

Still, in its 2013 outlook for the global banking system, Moody's says this year may prove to be less of a challenge than 2012, when the agency downgraded the ratings of most of the largest banks in the world including JPMorgan (JPM - Get Report), Bank of America (BAC - Get Report), Citigroup (C - Get Report), Goldman Sachs (GS - Get Report) and Morgan Stanley (MS - Get Report).
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