Bankers often accuse regulators of fighting the wrong war, and that divide is as visible as ever on the question of interest rate risk.

The banking industry is landing scores of short-term, low-cost deposits while the yield curve is at its steepest since the early 1990s, and investing the proceeds in long-term, higher-paying securities. But that profit model is threatened if the cost to obtain new deposits rises without a similar rise in the rates on new investments.

Regulators have been sounding the alarm that banks may be dangerously exposed to the inevitable jump in short-term rates. Yet industry executives used their fourth-quarter conference calls to tout securities purchasing, hedging and other strategies aimed at earning more from loans and securities than they would lose on liabilities when short-term rates rise.

For one, Rick Johnson, the CFO at PNC Financial Services Group Inc. [PNC], said his company is more interested in remaining flexible than in scoring short-term gains.

PNC has been buying "very short-dated government and Treasury securities," he said. PNC's ability to bring in low-cost deposits has allowed it to earn a decent return yet stay nimble, he said. "This is exactly where we want to be."

KeyCorp [KEY] officials said they have been investing in certain short-term mortgage backed securities. The company "is probably the most asset-sensitive we have been at least in my tenure at the company," said Jeff Weeden, the chief financial officer of KeyCorp. Weeden, who has been a Key executive since 2002, added, "So for rising rates, the company will benefit."

Bankers traditionally prefer steeper yield curves, when the spread between short-term and long-term rates is wide, observers said. That usually creates a good lending environment, but bankers are unable — or unwilling — to lend as they recover from the financial crisis.

Thus the temptation is to invest in long-term securities, but that practice could backfire if short-term rates come up to meet long-term ones.

Over and above short-term rates, banks' existing investments are also subject to movements on the long end of the yield curve.

Donald Mullineaux, a finance professor at the University of Kentucky, said if long-term rates were to rise, bankers would be hard-pressed to sell their existing securities at a higher price than they paid for them. "That makes you susceptible to lower margins and puts your earnings at risk," he said. "The risk is there."

Such concerns led regulators to issue a warning on Jan. 6 to banks about investing along the yield curve. The Fed and five other regulators issued an advisory that poor decision-making with hedging runs the risk of "placing downward pressure on capital and earnings."

D. Anthony Plath, a finance professor at the University of North Carolina at Charlotte, said there is a risk to banks "if the Fed takes dramatic action" on short-term rates. He said the biggest worry would be for those involved in the carry trade, or funding long-term assets with short-term liabilities, to generate a higher rate of return. The risk is that banks get "locked into long positions and are unable to unwind the assets."

Analysts said a typical scenario might involve using inexpensive borrowings from a Federal Home Loan bank to invest in 30-year Treasurys. Plath said trading desks must start unwinding positions to reduce exposure, or position into two- or three-year investments and certificates of deposit.

Banking companies rarely provide significant detail in such activities when presenting quarterly results, typically talking only about how hedging activity bolsters gains or offsets losses elsewhere.

But Wells Fargo & Co. [WFC] addressed its carry-trade position, saying that it was willing to reject short-terms gains from the practice in order to have more investment options later this year.

John Stumpf, the company's chairman and chief executive, said Wells was sacrificing as much as 400 basis points of gains "because we think there is a bias for higher rates, not for lower rates, and we are willing to wait for that to happen. We think that is the better trade."

Jamie Dimon, the chairman and CEO of JPMorgan Chase & Co. [JPM], said the New York company been selling securities to reduce risk in its portfolio. "Our interest rate exposure was high and it is way down," he said. "So honestly, I wouldn't worry about it that much."

Banks also must be mindful about how the curve impacts lending returns, observers said. Now is not the time to book fixed-rate loans. Fortunately, they said, virtually all commercial lending is variable rate and most fixed-rate residential mortgages are originated and sold to Fannie Mae or Freddie Mac, keeping that risk off the banks' books.

Plath warned that banks still need to be careful with any variable-rate loans they make, keeping in mind that rising rates can increase the interest payments on already struggling borrowers. "Repricing will hurt borrowers more than it hurts the banks," he warned.

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