S&P Global’s decision on Monday to downgrade credit ratings for a number of US banks and revise their outlooks underscores the complex operational challenges that have engulfed the nation’s financial sector. The move follows a similar action taken by Moody’s on Aug. 7, and both agencies have pointed to escalating funding risks and diminishing profitability as key stressors. The intricate web of challenges, factors ranging from funding risks to interest rate fluctuations, have precipitated these downgrades.
Funding Risks and Vulnerable Profitability
The S&P downgrades were swift and targeted, encompassing various institutions, most notably Associated Banc-Corp and Valley National Bancorp. The rationale behind these credit rating cuts hinged on their vulnerability to funding risks and an overreliance on brokered deposits, revealing a intricate nexus of challenges arising from the interplay of interest rates, deposit behaviors, and regulatory measures. A sharp rise in interest rates, as S&P said in a summarized note, is weighing on many U.S. banks’ funding and liquidity.
This precarious funding structure exposes these banks to heightened volatility and susceptibility to deposit outflows during times of economic turbulence, as evidenced by the large deposit outflows and prevailing higher interest rates leading to the downgrades of UMB Financial Corp, Comerica Bank, and Keycorp. This phenomenon has been worsened by the prevailing higher interest rates, (Current target rate 5.25–5.50), which have not only strained banks’ ability to attract deposits but also intensified the competitive landscape among institutions to retain existing clients.
The rising interest rate environment is particularly baffling, as it casts a shadow over the US banking sector’s funding and liquidity. The increase in rates has led to a decline in deposits held by Federal Deposit Insurance Corp (FDIC)-insured banks. This trend is set to persist as long as the Federal Reserve continues its “quantitative tightening.” This complex interaction between interest rates, deposit behavior, and regulatory actions has amplified the operating difficulties for US banks, as highlighted by the S&P’s decision.
Crisis of Confidence and Regulatory Measures
The specter of a crisis of confidence looms large over the US banking sector, a sentiment further fueled by the collapse of Silicon Valley Bank and Signature Bank earlier this year. This crisis prompted a run on deposits at various regional banks, despite the authorities’ implementation of emergency measures to restore confidence. The fallout from these collapses underscores the fragility of investor trust in the US banking system, a factor that has significantly contributed to the challenges banks are currently facing.
Moody’s recent downgrades and review for potential downgrades of larger banking giants such as Bank of New York Mellon, US Bancorp, State Street, and Truist Financial indicate that no institution is immune to the prevailing operational complexities. These actions by Moody’s mirror S&P’s concerns and reflect the broader industry-wide challenges that banks face.
Challenges of Regulatory Sector and Subsequent Outlook
The intricacy of regulatory efforts has further complicated the outlook for US banks. In recent years, regulators have sought to fortify banks against potential financial shocks by mandating higher capital reserves and greater liquidity. The evolving Total Loss Absorbing Capacity (TLAC) rules exemplify this trend, requiring banks to maintain sufficient capital and long-term debt at the holding company level. This move aims to safeguard banks’ operations while redistributing risk among stakeholders.
“When we get a recession, it tends to be because we had a problem with monetary policy,” CNBC once quoted William Luther, director of the Sound Money Project at the American Institute for Economic Research, as saying.
However, as depicted by S&P, uncertainties persist around the eligible debt instruments for TLAC compliance. This adds another layer of complexity to the operational challenges facing US banks. The fallout from the 2008–2009 financial crisis has triggered a wave of regulatory reforms, and the near-completion of TLAC rulemaking signifies regulators’ progress toward their overarching goal of minimizing taxpayer burden during a financial crisis.
This S&P’s downgrades and Moody’s actions underscore the multifaceted challenges that US banks confront in today’s complex economic landscape. Funding risks, deposit outflows, interest rate fluctuations, and intricate regulatory measures have coalesced to pose a formidable operational challenge. The crisis of confidence that emerged from recent bank collapses adds a layer of uncertainty and vulnerability to the equation.
“The biggest risk at the moment is that the Federal Reserve will over tighten monetary policy,” Luther said. “If it is too tight, then we will have a recession.”
Significant S&P Downgrades in Recent Past
In 2015, eight of the biggest US banks — including Bank of America, JPMorgan Chase, Citigroup, and Wells Fargo — had been downgraded by S&P, as the credit rating agency judged that the likelihood of federal government support in a future crisis had dimmed. The U.S. economy only only 0.7% between October and December of the year, the slowest pace since the first quarter of 2015, when the economy had grown at a 0.6% pace as parts of the country battled with blizzards and businesses shutting down.
After downgrading the credit ratings of 11 top global banks including Citigroup, Deutsche Bank and JP Morgan in 2011, citing increased industry risk and a deepening economic slowdown, S&P had written in a note, “The downgrades and revised outlooks reflect our view of the significant pressure on large complex financial institutions’ future performance due to increasing bank industry risk and the deepening global economic slowdown.”
The world’s largest economy had grown by just 0.4% between January and June that year – half the pace of growth in austerity Britain. To make matters even worse, the total loss of economic output during the 2007–2009 recession had been revised to 5.1% from a previous estimate of 4.1%.
As the US economy currently braces for an impending mild recession in early 2024, these banking institutions are expected to summon resilience and innovation to safeguard their credit strength, maintain investor trust, and weather the storm of operational intricacies.