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Banks' Worst Fear: Sudden Rise in Interest Rates

NEW YORK ( TheStreet) -- Banks are hoping a rise in interest rates will help lift their margins, but a sudden and unexpected rise in rates could prove to be a "double-edged sword," according to Nomura analyst Keith Murray.

A modest rise in interest rates could help most banks earn a better rate on their loans and because deposit rates typically respond with a lag, their "spreads"-- the difference between the interest rate earned on loans and investments and the interest paid on deposits - improve.

Some banks that are "liability sensitive" are hurt more by rising interest rates because they are more exposed to a rise in funding costs.

The prospect of a "rate-shock" concerns regulators and banks because a sudden, rapid increase in rates could catch them unprepared, leading to a sharp rise in their funding costs and a big hit to their bond portfolios.

Parallels are drawn to the mid-1990s, when rates increased dramatically causing large banks to underperform the broader market for several months.

This time it could be worse and not just for banks, as the financial industry has been operating in a period of prolonged low interest rates. "..a rate shock could be more troublesome this time around with real rates being negative, GSEs no longer buyers of last resort, elevated REIT leverage, already tight credit spreads, and potentially a lot of 'fast money' that has moved into fixed-income ETFs and could flow out quickly. These factors could add to rate volatility (though this could be a boost to capital markets' hedging activity in the short-term)," Murray wrote in a report Tuesday.

For banks, a complication this time is that a sudden rise in interest rates could hurt capital ratios that have been painstakingly built since the crisis. Unrealized gains and losses on "Available-for-sale" securities are counted towards Basel Capital III ratios. Low rates have boosted the value of these portfolios, helping banks build capital. But a sudden rise in rates could lower the market value of these securities and in turn, lower capital ratios, according to the analyst.

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