By Nicholas Larsen, International Banker
For the United States, August was, indisputably, a month to forget regarding credit ratings. Indeed, the month got off to a bad start when Fitch Ratings downgraded the country’s sovereign rating on the first day. The situation went from bad to worse one week later when Moody’s (Moody’s Investors Service) cut the credit ratings of 10 small and mid-sized American banks by one notch. S&P Global Ratings (S&P) followed suit by downgrading five lenders on August 21. These credit-rating actions have prompted widespread concerns over American lenders’ costs, profitability and specific exposures and have also raised crucial questions about the banking sector’s potential vulnerability to another crisis.
Red flags had already been raised before August’s negative actions. For instance, in March, Moody’s had placed six banks under review for downgrades and cut the industry’s outlook from stable to negative. On June 27, Fitch lowered the operating environment (OE) score for US banks—a measure that captures the assessments of a particular jurisdiction’s banks’ capabilities to generate business volumes while taking acceptable levels of risk—to “AA-” from “AA”, a move that reflected “downward pressure on the US sovereign rating, gaps in the regulatory framework and structural uncertainty around the normalisation of monetary policy”.
Such actions received muted responses from investors and the financial media, however, particularly given that no actual rating downgrades accompanied them. Nonetheless, they demonstrated that rating agencies were adopting a distinctly less favourable stance toward the US banking sector in the wake of the crisis that emerged in early March, with specific key factors catching the attention of analysts.
“The failure of three large US banks earlier this year brought into focus several vulnerabilities and gaps in the regulatory framework that failed to address significant asset/liability mismatches, deposit concentrations/outflow vulnerabilities and signalled a lack of utilization and enforcement of often-dormant existing supervisory powers,” Fitch noted at the time. “The lower OE score for US banks reflects an increasingly uncertain macroeconomic environment and the potential for sustained structural challenges to the US banking system should interest rates stay higher for longer.” The rating agency specifically cited the residual effects of unprecedented government stimulus during the pandemic as the main source of those structural challenges, with high and persistent inflation rates, interest-rate shocks and the Federal Reserve’s (the Fed’s) quantitative-tightening measures aimed at reducing systemwide liquidity transpiring as a result.
Moody’s initiated the first set of downgrades around six weeks later, with M&T Bank, Pinnacle Financial Partners (PNFP), BOK Financial Corporation and Webster Financial Corporation (WFC) among the 10 casualties. The rating agency also placed several major Wall Street lenders on review for potential downgrades, including Bank of New York Mellon (BNY Mellon), U.S. Bancorp (USB), State Street Corporation, Truist Financial Corporation, Cullen/Frost Bankers (CFR) and Northern Trust Corporation. Moody’s changed the outlooks for 11 other banks to negative, with Capital One Financial Corporation, Citizens Financial Group (CFG) and Fifth Third Bancorp among them.
Among the key factors contributing to the downgrades highlighted by Moody’s were some that were crucial in triggering the March banking crisis, with banks still exposed to depositor withdrawals of their funds and the persistent high-interest-rate environment severely eroding the values of the investments they made a few years ago when rates were much lower. And with large swathes of office space remaining empty across corporate America in this post-pandemic era, Moody’s noted that small and mid-sized banks with elevated exposures to corporate real estate (CRE) were particularly vulnerable.
“US banks continue to contend with interest rate and asset-liability management (ALM) risks with implications for liquidity and capital, as the wind-down of unconventional monetary policy drains systemwide deposits and higher interest rates depress the value of fixed-rate assets,” Moody’s analysts Jill Cetina and Ana Arsov noted in the report of the rating actions. “Meanwhile, many banks’ Q2 results showed growing profitability pressures that will reduce their ability to generate internal capital. This comes as a mild U.S. recession is on the horizon for early 2024, and asset quality looks set to decline from solid but unsustainable levels, with particular risks in some banks’ commercial real estate (CRE) portfolios.”
Many of those same factors appeared in S&P’s assessment as “potential risks in multiple areas” a few weeks later, when it slashed the ratings of five banks by one notch—KeyCorp, Comerica Incorporated, Valley National Bancorp, UMB Financial Corporation and Associated Banc-Corp (ASB)—whilst indicating negative outlooks for several other lenders. “For instance, some that have seen greater deterioration in funding—as indicated by sharply higher costs or substantial dependence on wholesale funding and brokered deposits—may also have below-peer profitability, high unrealized losses on their assets, or meaningful exposure to CRE,” the rating firm explained on August 21.
Indeed, many banks are now bearing much higher costs following the Federal Reserve’s series of aggressive interest-rate hikes starting last year, particularly from paying out more interest on deposits to prevent depositors from putting their money into higher-yielding alternatives. “These downgrades are mainly focused on the liquidity concerns now raised by multiple agencies where banks have a lot of loan portfolios that are only drawing 2.5-4.5 percent in interest income while now needing to pay depositors 4.5-5.5 percent in savings and money market accounts,” Brian Mulberry, client portfolio manager at Zacks Investment Management, explained to Reuters following S&P’s action.
And with the macroeconomic situation likely to deteriorate further, as the Fed’s rate-tightening cycle remains unfinished, additional downgrades could materialise before the year is out. Fitch Ratings analyst Christopher Wolfe stated that there are growing risks of dozens of banks being subject to negative actions by rating firms—including the biggest US lender, JPMorgan Chase & Co. And should Fitch’s OE score decline another notch from the “AA-” it administered in late June to “A+”, Wolfe said he expects that his rating firm will be forced to reevaluate ratings for every single bank of the more than 70 that it covers, as it would mean that the broader industry score would be below that of many of the sector’s top lenders. “If we were to move it to A+, then that would recalibrate all our financial measures and would probably translate into negative rating actions,” Wolfe told CNBC on August 15.
Should those top lenders lose a rung on the rating ladder from such assessments, Wolfe also contended, many weaker lenders could be considered for downgrades, which, in turn, would push them dangerously toward non-investment-grade status. “We’d have some decisions to make, both on an absolute and relative basis. On an absolute basis, there might be some BBB- banks where we’ve already discounted a lot of things and maybe they could hold onto their rating.”
But while these gloomy rating actions of recent months may highlight that some lenders are undoubtedly facing higher risks, most analysts suggest that depositors and investors have little about which to worry regarding the overall US banking sector. Indeed, S&P confirmed that while some lenders experienced negative actions against them by the rating agency, most US banks’ rating outlooks remain stable. “The preponderance of stable outlooks reflects that stability in the US banking sector has improved significantly in recent months, as evidenced by more modest deposit declines than feared following the bank failures of March and April 2023, continued solid earnings, and still relatively good funding metrics by historical standards,” S&P noted on August 21, shortly after issuing its downgrades. Zacks’ Brian Mulberry also observed that no immediate systemic risk was in the banking sector, despite the strains highlighted by the downgrades.
Nevertheless, there is no denying that the downgrade trend across the US banking sector will weigh on banks’ abilities to lend at competitive rates. With investors viewing them as riskier bets, borrowing costs will likely rise, meaning that smaller and mid-sized lenders, in particular, will remain vulnerable to mass customer withdrawals in search of safer yield options for the foreseeable future. “The banks’ cost of capital will go up,” according to Jay Menozzi, chief investment officer and portfolio manager at Orange Investment Advisors. “They can’t get squeezed from every direction, so in order to maintain what little profitability they have…one of the things that will have to give would be that consumers would face higher borrowing costs.”