NEW YORK, Nov 16: The recent US Federal Reserve rate cuts mean increased interest rate risk for many retail-funded banks and the mortgage banking industry, said a new Standard & Poor’s report released on Friday.

“Any time you are on the extremes of any rate environment, with either very high rates or very low rates, such a situation heightens interest rate risk on a relative basis,” said Robert Swanton, a managing director in the Financial Services group at Standard & Poor’s.

Before the September Federal Reserve rate cuts that led to further prime rate declines, the banking sector was experiencing interest rate risk equilibrium, with net interest margins stabilizing at most banks and mortgage prepayments balanced with new origination activity, said the report, The Effect of the Federal Reserve’s Rate Cuts on Interest Rate Risk.

The rapid and unanticipated interest rate slashes precipitated by the Sept. 11 terrorist attacks, encouraged consumers to take advantage of the low rates to prepay and refinance consumer mortgages. Corporate borrowers have also benefited from the mostly variable rate nature of their bank borrowings. On the mortgage banking side, for now, prepayments continue at unprecedented rates but largely offset by refinancing. However, the weak economy and poor consumer confidence may begin to take a toll on new home sales which would ultimately hurt revenues.

“Not surprisingly, consumer and corporation refinancing have significantly increased as a result of the recent interest rate cuts,” Swanton said. “In an environment with such low rates, we would normally see more corporate and consumer spending, which would, in turn, help the economy. But because of poor consumer confidence and corporate uncertainty, many spending plans have been delayed.”

While loan yields have generally declined for banks, their cost of funds may not have declined in lockstep. This is particularly true for those banks with relatively strong consumer deposit franchises. While such a customer profile is generally a positive for banks, the current interest rate environment makes it far less beneficial than in a higher interest rate environment.

Those banks with a large proportion of interest-free demand deposits, a high proportion of passbook savings accounts and that are highly capitalized are most exposed to weakened net interest margins.—Reuters