NEW YORK ( TheStreet) -- Though the world is bracing for banks to report the final quarter of a blockbuster earnings year, the time of cheap money that allowed them to finance it is about to come to an end. Inflation fears have been plaguing the market for months, reassured now and then by statements from the Federal Reserve, pledging to keep interest rates "exceptionally low" for "an extended period" of time. The Fed's rate target has been in a range of 0% to 0.25% for more than a year. Yet on Friday, the Fed and other bank regulators advised banks that they ought to be prepared for rates to rise. An unexpected rate hike could cause big losses on the assets that banks have hoarded to maximize profits in the low-interest rate environment. Banks could end up losing significant amount of money on certain types of securities, and see a spike in defaults on consumer loans that would climb along with the Fed rate. "Funding longer-term assets with shorter-term liabilities can generate earnings, but also poses risks to an institution's capital and earnings," warned the Fed and five other regulators that make up the Federal Financial Institutions Examination Council. The market has been prepared for a rate hike for some time, with the rate on 10-year Treasury notes climbing from 2.46% at the start of 2009 to 3.85% recently. The most sophisticated banks like Goldman Sachs ( GS), JPMorgan Chase ( JPM), Wells Fargo ( WFC), Bank of America ( BAC), Morgan Stanley ( MS) and Citigroup ( C) always have hedging strategies in place, using derivatives such as rate swaps, futures and options to offset risk and allowing them to act nimbly to rebalance asset mixes once rates begin to change. Wells Fargo -- which, like others, has a huge portfolio of rate-sensitive
mortgage-servicing rights -- estimated last year that its earnings would decline just 5% if the Fed rate climbed to 3.75% over a nine-month stretch. It's an event that's incredibly unlikely, unless inflation suddenly soars through the roof, but after the shocks of 2008, banks are hedging against even the least expected scenarios. "Interest rate risk can be just as detrimental to bank balance sheets as credit risk," says Aite Group senior banking analyst John Jay. "If the traditional 'borrow short, lend long' model is followed, a double-whammy may occur. Assets will decline in value and margins will be squeezed if the entire curve shifts upwards."
However, smaller and more conventional banks may not be as prepared. Some have only gotten more leery of fancy Wall Street instruments that would help them adapt more quickly to rate changes -- especially after losing money on plain-vanilla Fannie Mae ( FNM) and Freddie Mac ( FRE) securities, or having vast amounts of funds tied up in auction-rate securities, which were marketed to be as safe and liquid as cash. But the other side of the coin is that, even if banks face the potential for losses and narrower margins, a higher rate environment will incentivize them to make money in lending once again. The Obama administration has pushed banks to make more loans to cash-depleted consumers and small businesses, but banks have been slow to accommodate that goal, while tightening loan standards as the recession wore on. The potential to earn more money on loans may be just what the doctor ordered to fix the credit conundrum. The Fed's challenge will be setting rates low enough so that borrowers can afford them, but high enough so that banks are wooed into lending again. -- Written by Lauren Tara LaCapra in New York