The Unsteady Seas of The US Banking Industry

Earlier this year, the US banking crisis sent shockwaves through the global financial system. Silicon Valley Bank, Silvergate, and Signature, three mid-sized US banks, collapsed, triggering a domino effect that led to a drop in bank share prices worldwide. The Federal Reserve stepped in, providing substantial cash injections to these struggling institutions and establishing a credit facility to support others on shaky ground. However, the storm may not have entirely passed.

As traders return from their summer hiatus to a period of market turbulence, concerns loom large. In a bid to combat inflation, central banks have aggressively raised interest rates. The Federal Reserve's main interest rate shot up to 5.5% in July 2023, the highest level in two decades. Such a rapid adjustment can spell trouble for banks, particularly given the U-shaped rate movement since the 2007–09 global financial crisis.

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This sudden rate hike has led to a series of challenges for banks. It has eroded their asset values, increased borrowing costs, and squeezed profitability, leaving them more vulnerable to adverse events. In the first half of 2023, banks faced sluggish loan growth and elevated deposit costs. Clients, seeking higher returns, redirected their funds to money market funds, prompting banks to borrow more from the Fed at higher rates to maintain liquidity.

This series of events contributed to the spring bank crisis, destabilizing institutions as the value of their debt plummeted. This, in turn, triggered a wave of deposit withdrawals across the industry. Between June 2022 and June 2023, US bank deposits fell by roughly 4%, compounding the impact of rising interest rates.

Ratings agencies have further exacerbated the situation. Fitch's downgrade of US government debt to AA+ from AAA in early August signaled anticipated challenges in public finances. This has a knock-on effect on banks, lowering their creditworthiness and credit ratings. With diminished access to borrowing from markets or the Fed, banks face reduced lending capacity, weakened capital buffers, and struggling profitability.

Moody's followed suit, downgrading the credit ratings of eleven US mid-sized banks and threatening further downgrades for major institutions. S&P Global Ratings and Fitch are poised to do the same. Such downgrades intensify the risks and instability for banks, particularly when coupled with sovereign downgrades.

Despite these challenges, there is room for optimism. The sector may benefit from the stabilization of interest rates and bank deposits in the coming months. Larger banks are reporting improved margins from loan interest, offering a glimmer of hope amid the broader drop in profitability. Additionally, some banks anticipate a boost from increased deal-making activity later in the year.

In the face of these headwinds, regulators are taking action to fortify the US banking industry. Proposals to raise the minimum capital requirements for large US banks are on the table, a positive step toward enhancing their loss-absorbing capacity. However, these changes will take time, leaving the US banking sector susceptible to financial shocks and other crises in the interim. It will be months before we can ascertain if the worst is truly behind us.

In this precarious environment, vigilance and careful navigation will be key for both banks and regulators alike. The path ahead is uncertain, but with strategic measures and prudent decision-making, the US banking sector can weather the storm and emerge stronger on the other side.