Moody's warns of risks to US banks and lowers outlook of financial system to negative

Rating agency projects the US economy will slide into a mild recession in the latter part of 2023

Traders on the floor of the New York Stock Exchange. US stock markets closed higher while Treasury yields rose sharply on Tuesday. AFP

The US banking system faces risks amid the fallout from the collapse of Silicon Valley Bank and two other lenders as the Federal Reserve raises interest rates to curb inflation, Moody's Investors Service has warned.

The rating agency lowered its outlook on the US banking system to negative, from stable, due to the Fed's rapid monetary tightening and weak risk management that amplifies the underlying asset-liability management risks of banks.

Moody's said its decision follows the winding down of SVB, Signature Bank and Silvergate Capital that prompted the US Treasury Department, the Fed and the Federal Deposit Insurance Corporation to step in and guarantee that depositors would be able to recover all of their money.

“We have changed to negative, from stable, our outlook on the US banking system to reflect the rapid deterioration in the operating environment following deposit runs at SVB, Silvergate Bank and Signature Bank (SNY), and the failures of SVB and SNY,” the rating agency said in the outlook note.

In a separate note, Moody's said that while the three banks were unique in their focus on cryptocurrency and venture capital or private equity, areas of non-bank finance that grew quickly during the era of easy monetary policy, “it is increasingly evident that other US banks are also facing ALM strains”.

Lenders with substantial unrealised securities losses and “with non-retail and uninsured US depositors may still be more sensitive to depositor competition or ultimate flight, with adverse effects on funding, liquidity, earnings and capital”, Moody's said.

“Banks with lower unrealised securities losses, stronger capitalisation, diverse sectoral exposures and granular insured deposit bases will be more shielded or benefit from a flight to quality.”

Moody's said it assumed that the Fed’s monetary tightening would continue, which could deepen some banks’ challenges.

In a speech on Tuesday at an Independent Community Bankers of America conference in Honolulu, Fed Governor Michelle Bowman said the US banking system remained resilient and “on a solid foundation, with strong capital and liquidity throughout the system”.

“The board continues to carefully monitor developments in financial markets and across the financial system.”

Markets echoed Ms Bowman's view, with financial sector stocks and those of banks rebounding on Tuesday.

The S&P 500 gained 1.7 per cent at the close of trading while the Nasdaq Composite and the blue-chip Dow Jones Industrial Average settled 2.14 per cent and 1.06 per cent higher, respectively.

Pandemic-related fiscal stimulus and more than a decade of ultra-low interest rates and quantitative easing produced excess deposits in the US banking sector, Moody's said.

“This has given rise to asset-liability management challenges, with some banks having invested excess deposits in longer-dated fixed-income securities that have lost value during the rapid rise in US interest rates, resulting in significant unrealised losses in banks' available-for-sale and held-to-maturity securities’ portfolios,” it said.

“We expect pressures to persist and be exacerbated by ongoing monetary policy tightening, with interest rates likely to remain higher for longer until inflation returns to within the Fed’s target range.”

While inflation in the world's largest economy has come down after hitting a 40-year high last year, it remains elevated, with the annual Consumer Price Index for January rising by 6.4 per cent and by 6 per cent in February, well above the Fed's 2 per cent target rate.

The Fed faces a delicate balancing act when it meets next week to decide its monetary policy, as it considers the reverberations of further tightening to fight inflation against the backdrop of SVB's collapse.

The Fed started raising interest rates this week last year. Many on Wall Street criticised it for acting too slow and playing catch-up with inflation, which was initially considered transitionary.

However, as inflation in the US surged to above 9 per cent last year, a 40-year high, and a similar scenario played out in Europe, the Fed became more aggressive and resorted to a series of 75 basis point and 50 bps increases in an effort to restore price stability, stoking fears and criticism that overtightening may increase the risk of a recession.

“US banks also now are facing sharply rising deposit costs after years of low funding costs, which will reduce earnings at banks, particularly those with a greater proportion of fixed-rate assets,” Moody's said.

“Combined with this most recent stress in the banking sector, further interest rate increases could deepen some banks’ ALM and profitability challenges.”

Interest rate increases have reduced the economic value of securities held on banks’ balance sheets, it said.

In 2005, government securities held by US banks totalled $1 trillion, or 13 per cent of their combined balance sheet. Today, those holdings have ballooned to $4.4 trillion, or 19 per cent of US banking system assets, according to the rating agency.

Moody's expects the US economy to slide into a mild recession in the latter part of 2023, with real gross domestic product growth remaining below trend in 2024.

It also forecasts an increase in the US unemployment rate to under 5 per cent, from its low of 3.4 per cent in January 2023.

While the housing sector is already weakening, the real estate, construction and manufacturing sectors are set to decelerate as rising interest rates, a strong dollar and weaker growth in the trading partners of the US hit domestic demand and exports, the rating agency said.

Asset risk metrics will rise over the next 12 months to 18 months, from historical lows, with both non-performing loans and net charge-offs expected to rise, it said.

“Higher interest rates are reducing debt affordability, excess consumer and corporate liquidity is waning, and financial conditions, particularly bank credit, are tightening,” Moody's said.

“The deteriorating operating environment will be felt most keenly by banks exposed to deposit flight. Banks that are perceived to be the most stable will benefit from drawing deposits from other banks, with improvements to liquidity.”

Moody's expects headline and core inflation to decline over 2023 to 2024, allowing the Fed to move to “a neutral policy stance in 2025".