George, Esther

As a result of near-zero interest rates for five years, the profitability of traditional banking activities is strained and incentives to reach for yield are tempting. Net interest margins continue to trend lower and are at their lowest level in 30 years. Banks are responding as we should expect, which is to say they are engaging in riskier activities. For example, an all-time high of $600 billion of leveraged loans were issued in 2013. This lending is often characterized by weaker underwriting standards, including higher debt ratios and fewer covenant provisions.

The incentives to reach for yield extend to smaller financial institutions as well. Commercial banks with assets of less than $50 billion have increased exposure to interest rate risk, due in part to the guidance the FOMC has provided regarding future interest rates. Today, 53 percent of the securities and loans held by these banks have maturities of more than three years, compared to about 37 percent back in 2005. If longer-term interest rates were to suddenly move higher, these institutions could face heavy losses.