Regional banks have faced challenges from rising interest rates and deposit outflows, and these difficult operating conditions became apparent in March when SVB Financial's Silicon Valley Bank failed. Since then, three other banks have gone under -- Signature Bank, First Republic Bank, and Heartland Tri-State Bank.
Two weeks ago, Moody's downgraded several regional banks. Last week, S&P Global followed suit, downgrading five more amid a challenging operating environment for banks. Read on to see what banks S&P Global downgraded and what you should know before investing in the banking sector right now.
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Credit rating agencies are concerned about banks
The three major credit rating agencies have all put banks on notice in the past few months. In June, Fitch Ratings lowered its score of the U.S. banking industry's operating environment due to the country's credit rating, uncertainty about future regulations, and the Federal Reserve's interest rate policy.
In early August, Moody's downgraded the credit ratings of 10 small and mid-size regional banks, including Commerce Bancshares and M&T Bank. It also put six other banks on watch for potential downgrades, including U.S. Bancorp and Truist Financial. Most recently, S&P Global downgraded the credit ratings of five banks:
- KeyCorp (KEY 0.62%): $193 billion in U.S. assets
- Comerica Bank (CMA -0.15%): $90 billion in U.S. assets
- UMB Financial (UMBF -0.59%): $41 billion in U.S. assets
- Associated Banc-Corp (ASB 0.94%): $41 billion in U.S. assets
- Valley National Bank (VLY -5.79%): $61 billion in U.S. assets
High interest rates and deposit outflows weigh on some regional banks
S&P Global said KeyCorp, Comerica Bank, and UMB Financial received downgrades because of increased funding costs and ongoing deposit outflows, which have been directly affected by the Federal Reserve's interest rate policy. Since March 2022, the Federal Reserve has raised interest rates 15 times, sending its benchmark interest rate from near zero to 5.5% and making it the central bank's fastest rate hiking campaign ever.
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Rising interest rates can benefit banks because it means they can collect more interest on the loans that they make. This generally helps banks earn more interest income than they pay out in interest expense in deposits, which can raise their net interest margin (NIM).
However, some banks, like Silicon Valley Bank, were ill-prepared for the aggressive interest rate increases from the last year. Silicon Valley Bank catered to companies in and around the start-up community. The bank had a tremendous amount of non-interest-bearing and uninsured deposits. As interest rates continued rising, the bank began losing deposits at an ever-increasing rate. Combine this with a lack of funding in the start-up space, and Silicon Valley faced a deposit outflow reckoning that it could no longer bear.
Other banks struggled with falling deposits due to higher interest rates. Customers with non-interest-bearing deposits or ultra-low-yielding checking accounts may put their money elsewhere, including high-yield savings accounts or certificates of deposit (CDs), where they can earn interest north of 5% annually.
KeyCorp and Comerica saw deposit outflows and compressing margins
KeyCorp, the largest bank of the group, has seen its deposit base decline by nearly 5% since the end of 2021. Its non-interest-bearing deposits saw a much more significant 36% during that time, which has put pressure on its NIM. In the third quarter last year, KeyCorp's NIM reached 2.74%. However, declining deposit outflows and increasing funding costs have compressed its NIM, which is now 2.12%.
Comerica, the next largest bank of the bunch, saw its deposits decline 20% from the end of 2021 through June 30, with its non-interest-bearing deposits falling 32%. It has also seen its NIM decline recently, from 3.57% in the first quarter to 2.93% in the second quarter.
What investors need to know
In addition to falling deposits and declining margins, banks also face increased regulation. In a July speech, Michael Barr, the Federal Reserve's Vice Chair for Supervision, said he planned to pursue regulations requiring banks with $100 billion or more in assets to hold more reserves. Barr said regulators need to make the banking system more resilient in light of recent bank failures.
The recent downgrade from credit agencies doesn't necessarily mean these banks are in trouble, but it reflects the increased risks that banks face. The Federal Reserve has dramatically increased interest rates from record-low levels, and it will take time for the full effect of higher interest rates to trickle through the economy.
If you're considering buying bank stocks, you may want to avoid those more vulnerable to the challenges today and focus on those with strong balance sheets and management teams that can better weather the storm.
