What's Going On With Banks? Mixed Picture?

By Patricia Healy, CFA

It was well known that banks would be challenged as the Fed raised the Fed funds rate to battle inflation, intentionally reducing bank lending to businesses and individuals and thus dampening economic activity and inflation. A recession was predicted by many, as a recession is what usually happens when the Fed tries to cool the economy and the yield curve inverts, making short-term rates higher than long-term rates. Predictions of the timing and depth of a recession favored a soft landing but are now challenged by recent Fed member statements that rates may be higher for longer to fight inflation.

Banks earn money from interest income on making loans and from earnings on their invested capital, and as most of us know - fees. They are funded by deposits and by issuing debt. As interest rates rise, loans become costly, generally reducing demand from borrowers, while fixed-income investments decline in value. On the funding side, banks pay higher interest rates to attract deposits and pay higher interest on debt issuance and other borrowings. In a weakening economy, banks are expected to experience higher delinquencies and charge-offs. Capital levels set by regulators can increase stability but can also leave less funds for lending and improving earnings.

Silicon Valley Bank, Signature Bank (OTCPK:SBNY), and First Republic (OTCPK:FRCB) had narrow deposit bases (few depositors with large balances compared with many customers with deposits of all sizes balances) and a large number of long-term bonds in their investment portfolios that declined precipitously in value as interest rates rose quickly last year, eroding capital. As usual with bank failures, there was a loss of confidence because of the swift decline in capital, and depositors pulled funds. Many of the depositors were large hedge funds that acted very quickly to extract their money. SVB and Signature failed, and shortly thereafter First Republic did, too.

Regulators and market participants stepped in to take over the banks that failed and to protect depositors, while investors in both debt and equity in those banks lost. After the FDIC guaranteed all deposits regardless of amount, SVB was taken over by First Citizens Bank (FCNCA), and part of Signature Bank went to New York Community Bancorp. (NYCB). First Republic went to JPMorgan Chase.

The Fed's Bank Term Funding Program (BTFP) gave banks access to substantial liquidity to help assure that banks would have the ability to meet the needs of all their depositors. This move gave depositors the comfort of keeping their deposits in place. Many credit the Fed's actions with saving us from a true banking crisis. The BTFP advances, up to one year in length, were collateralized by eligible securities such as Treasury and agency securities valued at par, not at the lower, discounted value that many bonds fell to. The BTFP facility is in place at least until March 11, 2024. If commercial real estate loans become problematic, some think the Fed could allow banks to use the facility or a similar one to insulate them from problem loans.

Bank Downgrades

Since March, Moody's and S&P have downgraded numerous banks in response to the banking crisis and the weaknesses it exposed. In August, there was another round of rating actions. In early August, Moody's took negative action on 27 banks, downgrading 10, placing 6 under review negative, and changing the outlook to negative on 11. Later in August, S&P downgraded 5 banks, with several others assigned negative outlooks. In mid-August, Fitch also released a comment on US banks. We expect bank ratings will continue to be pressured, given the environment and the number of banks currently with negative outlooks or under review.

The rating agencies note that higher rates are pressuring borrowers, and nonperforming assets, delinquencies, and charge-offs are rising toward at least their historical averages (so not a crisis yet). Amid higher-for-longer interest rates, the agencies expect further asset quality deterioration. Banks with material exposures to commercial real estate (CRE), especially in office loans, could see some of the greatest strains on asset quality, depending on the makeup and quality of underwriting on their portfolios.

The American Bankers Association took issue with the rating agency assessments in a strongly worded release on their website. The association noted that lending rates are rising so margins should not be squeezed as much as assumed by the agencies and that floating-rate loans and refinancing maturities have somewhat buffered net interest margins. Capital ratios are higher than required by regulators, and real estate portfolios are highly diversified. The regional banks do have higher levels of commercial real estate, but many banks have indicated that the commercial real estate may be in more resilient subcomponents of office space, such as medical space, suburban office buildings, and newer class-A properties.

Despite the rosier outlook from the bank trade association, not all is rosy for lower-rated banks with less diversified lending portfolios and large holdings of longer-dated investments, especially considering a potential economic slowdown and the refinancing needs of commercial real estate, as well as regulatory changes.

Going Forward

Lending activity for Q3 is down at large-cap banks, led by lower commercial, industrial, and CRE lending and somewhat offset by credit cards and multifamily lending. Some regional banks and credit unions are selling consumer loans that have higher capital requirements to asset managers to conserve capital in the face of increasing regulatory capital requirements. S&P Market Intelligence noted that the shift to shrinking balance sheets followed recent commentary from banks stating that growth is currently not a priority for a variety of reasons, including the high cost of funding, the potential downturn of credit-quality metrics, and looming changes to how risk-weighted assets (RWAs) are computed.

Commercial Real Estate Exposure

Commercial real estate loans, especially for office buildings, remain a concern for regional banks. Building owners may not want to or be able to refinance because of fewer tenants, less cash flow, and thus lower asset values - and banks may end up owning the buildings. Banks are differentiated by diversification of asset type, region, and time to loan rollover or maturity.

Regulation

Regulatory changes are intended to make banks stronger through higher capital requirements, improved liquidity, and increased liquidity reporting and resolution planning to avoid costly restructuring. Increased capital requirements could leave less funds for lending and earnings. Other proposed changes require more transparent disclosure, such as highlighting unrealized gains and losses in investment portfolios. The steep decline in fixed-income assets was a contributor to the reduction in capital at the failed banks, as mentioned earlier, so now there will be a greater focus on that risk - and more reporting requirements, increasing costs and possibly limiting flexibility.

The large GSIBs (global systemically important banks) have been participating in a Fed pilot program to assess the climate-related risk of their loan portfolios under various scenarios - including a hurricane in the Northeast. The importance the Fed places on climate risk has been noted in speeches by Secretary Yellen, referencing the Treasury's "Principles for Net-Zero Financing and Investment." This exercise includes accounting for Scope 3 emissions, which requires an assessment of the emissions of customers and vendors - a difficult task. There are no capital requirements associated with the scenario impacts at this time.

S&P is proposing a new special-purpose rating at the issuer level for banks that excludes the impact of potential extraordinary government support. This is positive for analysts and investors, allowing them to see how banks are ranked on a standalone basis; and it will be interesting to see how much the government support props up a particular bank's rating. Extraordinary governmental support is also considered by investors; and although depositors in the failed banks were saved in March, investors still lost out.

The news of depositors pulling funds from SVB, Signature, and Republic in March prompted us to review our bank holdings and exit the ones we thought might be more vulnerable to a downgrade, particularly the regional banks. We already had underweight banks directly in our equity strategies and noted that the weak performance of banks and financials had been a drag on broad "value" allocations. Regarding our taxable fixed-income strategies, as we have often discussed, we hold taxable municipal bonds because of the generally better credit quality of munis compared with corporate bonds. However, we also invest in Treasurys and other government-related bonds, as well as investment-grade corporates, including banks. We currently hold GSIBs in the US, some super-regional banks, and large diversified financial institutions that have associated banks. In our Q1 credit commentary we noted that municipalities have generally diversified their exposure to regional and other banks - yet another lesson learned from the 2008 financial crisis - in addition to holding larger rainy-day funds and implementing better budgeting constraints.

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