Bank Rate Bomb Will Destroy the Smallest and Weakest

NEW YORK ( TheStreet) -- U.S. community banks are not prepared for the possibility of a quick spike in rates when the ballooning federal deficit comes home to roost within the next few years.

While all banks will suffer in a Greek-like interest rate environment, smaller banks and thrifts are least prepared for the economic doomsday scenario.

Frank A. Mayer -- a partner in the Financial Services Practice Group of Pepper Hamilton LLP, in the firm's Philadelphia office -- says that bank regulators "within the last 18 months have been issuing a great deal of supervisory guidance on managing interest rate risk," since there's nowhere to go but up, "from an interest rate risk point of view."

"This is particularly important for thrifts," -- which have transitioned from being supervised by the Office of Thrift Supervision to the Office of the Comptroller of the currency, as required under the Dodd-Frank Wall Street Reform and Consumer Protection Act -- since many thrifts "have never run an interest rate risk model, lacking the expertise," according to Mayer.

The U.S. national debt of over $15 trillion is a topic frequently avoided by people looking to manage stress, but the debt represents a dire threat to smaller banks over the next several years.

Despite a debt roughly matching the annual gross domestic product -- similar to Greece's debt load -- the Federal Reserve has had a relatively easy time keeping short-term interest rates near zero, and the market rate for 10-year U.S. Treasury paper was just 1.92%, as of Wednesday morning, falling from roughly 3.50% two years earlier, and 4.55% at the end of February 2007.

So the "deficit without tears" -- in the words of French economist Jacques Rueff -- goes on, as the rest of the world continues to use the U.S. dollar as a reserve currency and international investors continue to put their excess liquidity into U.S. Treasuries.

So what does the obscene national debt mean to U.S. banks in the current environment, and what does it mean going forward, when rates eventually rise, as the economy continues to strengthen?

Mayer says that "interest rate risk stress testing is very important going forward," and that banks and thrifts may need to stress tests for scenarios of rate hikes of as much as 400 basis points in a year.

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