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Rising Interest Rates Focus for Bank Stress Tests

Victor J. Blue | Bloomberg | Getty Images

The Fed is opening the kimono a little more—this time to the banks.

The Federal Reserve Bank of Boston on Wednesday convened bank officials for a two-day symposium to discuss stress tests—the make-or-break bar set by the Fed that determines which banks are well capitalized enough to return money to shareholders.

The test's stakes are high, but its details are few: Most banks have complained that the Fed's methodology is too opaque and that banks are modeling for too many unknowns. The symposium will be the second annual attempt to change that, with one big elephant in the room—interest rates.

The Fed might not be raising interest rates in the near term, but that hasn't stopped fixed income investors from rushing for the exits, causing yields to spike, and prices to plummet. Outflows from bond mutual funds and ETFs in June so far have totaled $61.7 billion, data from TrimTabs show, even higher than the outflows during October 2008 at the height of the financial crisis.

It's an excruciating risk for banks in the business of underwriting low-interest mortgages and bonds, which—if left on the balance sheet—have been declining sharply in value before the higher interest income materializes.

"We need to be prepared for rapidly rising rates, potentially even worse than we have seen in recent history," JPMorgan Chase CEO Jamie Dimon wrote in his letter to shareholders, citing the fallout from 1994 and 2004, when short- and long-term rates rose 300 basis points within a year.

Previously the Federal Reserve's stress tests have included scenarios with sharp rises in unemployment and volatility, coupled with sharp drops in housing and equity prices. The Federal Reserve, banks have said, is now making sure banks have modeled for an eventual rise in interest rates, possibly even a dramatic one.

JPMorgan is among banks that have prepared for that risk. In addition to outlining its various hedges in investor presentations, a person familiar with the matter said, JPMorgan's internal stress test found the bank could withstand sharp rises in yield.

Citigroup, according to the company's March 2013 presentation, stressed the deposit and loan balances against "scenario-specific interest rate and foreign exchange rate projections"; though the exact scenario remains unknown, Citi posted the highest capital level of its peer banks.

(Read More: Rising Interest Rates: How Investors Should Be Positioned)

For banks that haven't subjected their balance sheets to interest rate stress, the Fed is mandating. Wells Fargo, the nation's largest mortgage provider, plans to stress its balance sheet for a 200 basis-point rise in both yields and rates.

It's not an unrealistic scenario for a housing-heavy bank, since mortgage prices have risen in tandem with Treasurys: At the end of the first quarter, Wells had $252 billion in first mortgages, on average yielding 4.29 percent. Those same mortgages now would cost nearly 5 percent.

No surprise then that the Office of the Comptroller of the Currency recently labeled interest rates one of the top operating risks facing the banks in the current environment, especially as many underwrite higher-yield or longer-term debt to earn more money in interest.

"When interest rates increase, banks that reached for yield could face significant earnings pressure, possibly to the point of capital erosion," the OCC wrote.

And capital erosion is exactly what the Fed—and the stress tests—are out to protect. Higher interest rates eventually will mean fatter earnings for financial institutions, but not until there's light at the end of the QE tunnel.

By CNBC's Kayla Tausche. Follow her on Twitter: @KaylaTausche.

Banks