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Fed Pushing Banks Back Into Risky Business: Moody's

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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.

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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 is 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 far more risk than what banks 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 risk for the global banking system -- 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.

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.

Currently, the 10-year US 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%.

In the US, a third round of monetary easing by the Federal Reserve in September targets the mortgage market and has pushed 30-year Fannie Mae (OTC:FNMA) mortgage rates near all-time lows at 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 US.

A dangerous cocktail of increasing risk appetite and low interest rate policies may prove a negative for the ratings of US banks, were they to dial up risk too far on financing arrangements and securities holdings.

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

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 it downgraded the ratings of most of the largest banks in the world including JPMorgan (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE), Goldman Sachs (NYSE:GS), and Morgan Stanley (NYSE:MS).

Other risks aside from macroeconomic issues and low interest rates include fragile investor confidence on the financial sector, and new regulations that may cause banks to raise further capital and liquidity.

Notably, Moody's 2012 bank ratings downgrades hinged on the assumption that the US government will be reluctant to bail out large financial institutions, were a new crisis to emerge. As regulators continue to hammer out laws to resolve troubled banks, the agency still sees the prospect of ratings pressure.

On the positive side, Moody's says revamped liquidity and a focus on increasing regulatory capital through the crisis puts US banks in a far more stable position in the wake of the crisis.

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