The Federal Reserve is scrutinizing the nation’s biggest banks to ensure they can handle an eventual rise in interest rates, as concern grows among regulators about the risks posed by a long low-interest-rate environment.

On Thursday, a panel of federal regulators charged with identifying market risks warned that a sudden rise in interest rates could have a destabilizing effect on financial markets. The Financial Stability Oversight Council, in its third annual report, cited interest-rate risk as one of seven major vulnerabilities to financial stability.

“A sudden spike in yields and volatilities could trigger a disorderly adjustment, and potentially create outsized risks,” the council said in its report.

Getty Images Ben Bernanke is part of a panel charged with identifying market risks.

The Fed’s chairman, Ben Bernanke, sits on the FSOC. Using detailed data that the central bank started collecting after the financial crisis, Fed officials are regularly running big banks’ portfolio holdings through models to gauge their exposure to various changes in interest rates, according to Fed officials.

For the first time this year, the Fed asked banks to gauge their ability to withstand a hypothetical inflation and interest-rate shock as part of an annual “stress-testing” exercise.

According to Fed officials, none of the 18 largest U.S. banks saw their capital levels fall below regulatory minimums under the scenario, which featured a mix of moderate recession, rising consumer prices and rapid increases in short-term interest rates, as might occur if oil prices were to shoot sharply higher. The Fed didn’t publicly release results of the scenario.

The Fed found that banks are protected in part because they have increased capital levels and because their net interest income would increase with a rate rise. They also have an inexpensive source of funds in customer deposits, which would insulate them, it found.

The Fed isn’t expected to raise rates any time soon, and the monitoring isn’t a signal that the central bank might shift its position—it has committed to holding rates low for a long time, at least until unemployment falls below 6.5%, as long as inflation remains stable.

The vast majority of the Fed’s 19 policy makers don’t believe the central bank will raise short-term rates until 2015 at the earliest.

Fed officials said they haven’t seen any major vulnerabilities appear yet. Regulators have issued a steady drumbeat of warnings that banks need to be prepared for rate increases and for the impacts that a rate spike would have on their funding costs and investments.

The latest came Thursday, when the FSOC said the sustained low-interest rate environment may have led some financial institutions, including banks, to seek out higher returns by investing in longer-term securities. The council said bank supervisors and market participants “should be particularly attuned to signs of heightened interest rate and credit risk at depository institutions, credit unions, broker-dealers and bank holding companies.” The FSOC warned that while so-called reaching for yield may boost near-term earnings, “it could significantly increase losses” if rates rise.

The Fed’s concern stems in part from the situation that arose in 1994 when, after a relatively long period of low interest rates, the central bank began raising short-term rates to deal with rising inflation. The response caught market participants by surprise: Rates rose dramatically, bond markets plunged and investors suffered big losses. The fallout helped sink brokerage firm Kidder, Peabody & Co., pushed Orange County, Calif., into bankruptcy and wiped out a hedge fund run by Askin Capital Management that had made leveraged bets on mortgage-backed securities.

Banks are exposed to interest-rate risk in several ways, including through the value of their long-term bond holdings, which fall as interest rates rise. That could result in losses as banks are forced to reflect the declining value. Treasury and government backed mortgage securities account for about 14% of bank portfolios, up from less than 10% before the financial crisis though not as high as more than 20% in the early 1990s, according to Fed data. And if the Fed raises short-term interest rates, the banks’ borrowing costs could go up.

The Fed and other banking regulators put out guidance in January 2010 telling firms to beef up their measurement and management of interest rate-related risks, highlighting regulators’ concerns that banks could get caught off guard by rising rates. Among the instructions were for banks to conduct stress tests using assorted rate scenarios, including “instantaneous and significant” increases in rates and prolonged rate shocks.

The risk extends beyond banks to pension funds, insurance companies and other financial entities that invest in financial assets. The longer the low interest-rate environment persists “the more very low interest-producing assets accumulate on their balance sheets,” said Sheila Bair, former chairman of the Federal Deposit Insurance Corp. “At some point the Fed’s going to have to raise rates, and the market value of those lower-yielding assets are going to go down.”

Michael R. Crittenden contributed to this article

via Fed Zeroes In on Banks’ Vulnerability to Rate Rise – WSJ.com.