S&P Global Ratings downgraded five regional US banks by one notch and signaled a negative outlook for several others on Monday. This action comes on the heels of Moody’s ratings actions on banks just two weeks prior.
The ratings agency said in a research note that the current “tough” lending environment caused it to downgrade the five banks, which include KeyCorp, Comerica Inc., Valley National Bancorp, UMB Financial Corp. and Associated Banc-Corp.
To be clear, the rationale behind these ratings actions is not new. The primary reasons that both ratings agencies took these actions was:
- Increased losses on banks held to maturity portfolios due to the increase in interest rates,
- Funding pressures for these banks. Deposits are now costing banks more due to rate increases,
- Deposit outflow from banks into higher yielding investments,
- High rate of uninsured deposits (those deposits likely to be quickly withdrawn at the first signs of trouble),
- Increased regulatory scrutiny, and
- Potential need for additional capital as a result of losses and potential stress test results applied to mid-sized banks.
Again, with the exception of deposit flight and increased regulatory scrutiny, net interest margins (the difference between what banks earn on their loans and the cost of their funds) of banks are impacted as deposit costs increase, mark-to-market losses on held-to-maturity portfolios (and on balance sheet loans) increase as interest rates increase, and deposits will flow to higher interest rate vehicles as rates increase. This is not new, nor is it fully a factor of bank failures seen earlier this year.
We expect that banks will have to raise additional capital to fulfill regulatory requirements (often expressed as TLAC, or total loss absorbing capacity), margin pressures will increase, and more onerous stress tests will be put back in place for mid-sized banks. We do not see a systemic risk resulting from the current environment. We also expect that valuations on banks (stocks and bonds) will drop as they address these issues, and, at some point, will make investment in this sector more attractive.
As the following charts illustrate, the price-to-book and price-to-earnings ratios of both domestic regional banks (the rating agencies current focus) and overall domestic banks is below their ten-year average, with the regional banks approximately one standard deviation below its average price-to-book and price-to-earnings ratios:
The same is also true for bank bonds, in this case 10-year single A rated bank debt versus the yield on U.S. Treasuries:
While these charts imply that banks are “cheap” relative to historical measures, one has to consider the current environment and expected future environment and the impact on profitability and the return of capital.
Earlier we stated that depositors are withdrawing funds from banks and putting their funds in liquid money market funds. We continue to recommend this to clients for a healthy amount of their liquidity. Consider that the average deposit rate for banks in the U.S. is approximately 0.56 percent (as per Bankrate on 8/14/23) while money market funds (government funds with a fixed price) yield over 5 percent (according to Crane Data). On a $25,000 account, the income difference per year is over $1,000.
The bottom line is that we are not overly concerned with the health of the banking system, but we do recognize the challenges to the banking system and the resultant re-pricing of bank securities.
The views stated in this blog (report) are not necessarily the opinion of Cetera Advisors LLC. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed.