The Looming Risk In The US Banking Sector – Analysis

By Wei Hongxu

The collapse of Silicon Valley Bank triggered a banking crisis in Europe and America, which stabilized for a period after the acquisition of Credit Suisse. However, following another interest rate hike by the Federal Reserve in July, the situation has shown further signs of deterioration.

First, a U.S. regional bank, Pacific Western Bank (PacWest), announced its merger with Banc of California, indicating that regional banks in the U.S. are still seeking self-rescue. Shortly after, Heartland Tri-State Bank, a small bank in Kansas with only 4 branches, declared bankruptcy and was taken over by the Federal Deposit Insurance Corporation (FDIC). This marks the fifth bank failure in the U.S. this year. Despite its smaller scale compared to the other four banks, this serves as a reminder that the crisis in the American banking industry is far from settled.

In August, the situation facing the U.S. banking industry further deteriorates. Especially after the Fed’s rate hike, the three major international credit rating agencies began to downgrade credit ratings related to entities in the U.S. For the first time in history. Fitch downgraded the credit rating of U.S. sovereign debt from AAA to AA+. While this action may not pose an immediate threat to U.S. government bonds and does not imply an imminent default, its consequences include an increase in risk-free rates in the U.S. This translates to higher borrowing costs for American businesses and financial institutions, which also implies the devaluation of existing assets such as U.S. government bonds.

To make matters worse, on August 7, Moody’s downgraded the credit ratings of ten small to medium-sized American banks including M&T Bank, Prosperity Bank, Webster Financial, and others. At the same time, the agency placed six large banks, such as Bank of New York Mellon and Truist Financial Corp on the watchlist for potential downgrades, indicating that these major banks also face the risk of credit rating adjustments. While Moody’s, among the three major international credit rating agencies, still maintains the AAA sovereign credit rating for the United States, its concentrated adjustment of the credit levels within the American banking sector undeniably introduces new instability factors to these banks, exposing them to liquidity risks. The Wall Street Journal believes that Moody’s downgrade of numerous American bank credit ratings has raised concerns about credit tightening and the resilience of the American banking system. This has led to a sell-off of financial stocks in the U.S. stock market, causing a collective decline in the major stock indices. In fact, Moody’s actions merely shed light on the challenging environment faced by various American commercial banks under the continuous interest rate hikes by the Fed. This, in essence, signifies that the crisis in the American banking industry is not merely a short-term cyclical or market issue, but a reflection of policy-related risks.

Prior to this, research including that from institutions like the Fed has repeatedly pointed out related issues. On July 13, the Fed’s Beige Book indicated that the American banking industry remains in a sluggish state. A previous report released by the Fed also highlighted that after the collapse of three banks, over 700 banks faced significant solvency risks due to losses exceeding 50% of their balance sheets, and even the possibility of collapse. Another recent report from the Hoover Institution arrived at similar conclusions. The report stated that the assets of 2,315 American banks were valued lower than their liabilities, with the market value of their loan portfolios being USD 2 trillion less than their book value. Consequently, U.S. financial regulatory authorities have consistently supported smaller banks. As reported by the Financial Times, by the end of June, the Federal Home Loan Banks (FHLB), with U.S. government backing, had extended loans totaling USD 880 billion to American banks and credit unions. This figure is slightly below the peak of USD 1 trillion FHLB reached at the end of the first quarter of this year, but it still represents an increase of over 150% compared to the loan level at the end of 2021. Furthermore, the balance of the Fed’s bank term funding facility launched in March to address the crisis remains at USD 105 billion as of July 26. This signifies that the U.S. financial regulatory authorities are currently compelled to provide support of nearly a trillion dollars to various banks, preventing them from collapsing due to imbalances in their assets and liabilities.

As previously pointed out by researchers at ANBOUND, the fundamental cause of the U.S. banking crisis lies in the tight monetary policy pursued by the Fed. To a certain extent, the successive “bankruptcies” in some regional banks in the country are a result of continuous interest rate hikes. Therefore, under the circumstances of the Fed maintaining its tight monetary policy, the persistently high-interest rates will place pressure on banks with relatively high leverage to experience declining performance and an increase in non-performing assets. Coupled with the continuous erosion of asset book values, the U.S. banking crisis is likely to continue and exacerbate. Moody’s stated that “many banks’ second-quarter results showed growing profitability pressures that will reduce their ability to generate internal capital”. It added that “this comes as a mild U.S. recession is on the horizon for early 2024 and asset quality looks set to decline, with particular risks in some banks’ commercial real estate (CRE)portfolios”. Additionally, Moody’s believes that U.S. banks are still dealing with higher interest rates and asset-liability management (ALM) risks, which impact bank liquidity and capital as unconventional monetary policies gradually come to an end, and deposit outflows within the system will gradually occur, causing an overall rise in fixed-rate asset values.

It should be noted that the increase in interest rates leads to the devaluation of bank financial assets and raises the cost of corporate financing, affecting corporate profits and refinancing, further impacting asset prices. If the spread of systemic risks occurs, this could lead to the recurrence of a financial crisis.

However, in the situation where U.S. inflation remains significantly above the 2% target, the Fed faces challenges in altering its policy. If the Fed continues to maintain a high-interest rate policy, the corresponding need for funding support remains indispensable, which is also detrimental to inflation control. In this dilemma, the risks brought about by the U.S. banking crisis become a vulnerability to the U.S. economy, and will likely have a prolonged impact on the stability of the American financial and economic sectors for a certain period of time.

Final analysis conclusion:

Against the backdrop of the Federal Reserve’s ongoing interest rate hikes, there is a trend of further deterioration in the risk landscape of the U.S. banking sector. On one hand, some regional banks continue to face challenges, leading to bankruptcy or acquisition. On the other hand, rating agencies have started recognizing the peril of deteriorating credit risks in the American banking industry and have adjusted their credit assessments accordingly. The root cause behind the persistent risks in the U.S. banking sector lies in the impact and influence of the Fed’s continuous interest rate hikes on the banking system. This has turned the issue into a systemic risk vulnerability.

Wei Hongxu is a researcher at ANBOUND