Ratings agency S&P Global announced a cut in its credit ratings on some regional lenders with high commercial real estate (CRE) exposure. The move follows downgrades of several mid-sized banks and their outlooks by Moody’s a couple of weeks back and is another reminder that the March banking sector crisis is not yes completely behind us. The S&P has warned about the implications of high interest rates on the banking sector and sees risk from rising funding costs and eroding profitability. An analyst from Fitch Ratings had also warned that the entire banking industry could be downgraded to A+ from AA-, which could trigger cuts for some of the country's largest banks and sweeping downward adjustments for their smaller rivals.
The rating agency lowered ratings for Associated Bank (ASB), Comerica (CMA), Key Bank (KEY), UMB Financial Corp (UMBF), and Valley National Bancorp (VLY). It also revised outlooks for River City Bank and S&T Bank (STBA) to negative while maintaining a negative outlook for Zions Bancorporation (ZION). As a result, the SPDR S&P Regional Bank ETF (KRE) fell 2.9%, slipping below the 38.2% retracement level from the May low.
The banking sector, once again, is facing several pressures:
- Higher interest rates have forced banks to pay more for deposits. Smaller regional banks have been impacted in a large way further since the March crisis as depositors rushed to move their deposits to safer large banks.
- High yields continue to translate into unrealized losses on Treasury and other bond holdings for banks and erodes their liquidity position. Fed’s special assistance program announced in March, which allowed banks to swap highly rated long-term securities that were under water in exchange for a 12-month cash loan equal to the face value of the paper, continues to be in demand.
- Weakening loan demand in the wake of high inflation and interest rate environment.
- Loan losses are also escalating, and US banks suffered almost $19bn of losses on soured loans in Q2 amid rising defaults among credit card and commercial real estate borrowers.
- Exposure to commercial real estate, particularly the office sector, is continuing to haunt. Working from home has cut into office values and almost $1.5 trillion of commercial property debt is due for repayment before the end of 2025. Meanwhile, rising interest rates have made many properties less valuable.
With event risk from Jackson Hole ahead, all eyes are on whether Fed Chair Powell acknowledges these risks to the banking sector and the impending credit risks to the US economy as a whole. Given the structural nature of these issues, and a structural focus of the symposium that is to be held at the end of this week, there is reason to believe that we could get comments on the operating environment of banks. Even if the Fed continued to emphasize higher-for-longer interest rates, banks will likely still face pressure from higher funding costs and weak loan demand, while also suffering on their balance sheets from asset/liability mismatch.
These rating downgrades could translate into tighter lending standards, and that could be detrimental to the health of the US economy particularly the high yield sector. The latest Senior Loan Officer Opinion Survey (SLOOS) showed that lending standards tightened across nearly all categories in Q2 for the fourth consecutive quarter. Survey respondents expected further tightening ahead, particularly in commercial real estate, credit cards, and commercial and industrial loans to small firms.