Moody’s downgrading US banks reflects eroding governance

In a span of mere days, the edifice of American financial prowess appears to be crumbling, beset by one shock after another. Just days ago, Fitch Ratings gave a big hit by lowering the credit rating of the US government. And now, more bad news: Moody's, this Monday, lowered the credit ratings of several small to medium-sized US banks. Moody's took the axe to ratings, dropping 10 banks by a notch. Meanwhile, financial giants like Bank of New York Mellon, US Bancorp, State Street, and Truist Financial are left dangling as they face the ominous prospect of potential downgrades, perched on the edge of a rating precipice.

“Meanwhile, many banks’ Q2 results showed growing profitability pressures that will reduce their ability to generate internal capital. This comes as a mild US recession is on the horizon for early 2024 and asset quality looks set to decline from solid but unsustainable levels, with particular risks in some banks’ commercial real estate (CRE) portfolios,” Moody’s explained the key factors in a note. As per Moody’s analysts, the American banking system is ensnared by the continued tribulations because of soaring interest rates and asset-liability management perils, setting the stage for a liquidity and capital conundrum. The aftermath of unconventional monetary policies drains systemwide deposits, and as interest rates rise, it shadows the credibility of fixed-rate assets, magnifying uncertainty within the financial domain.

At the start of this year, the collapse of both Silicon Valley Bank and Signature Bank ignited a frenzied deposit exodus that rippled across the sector. The panic's tendrils extended beyond borders, grasping Europe in its grip. Despite efforts by the US Treasury to mend faith in the financial system, Moody’s analysts sounded a cautionary alarm. Their caution reverberates: banks carrying significant unaccounted-for losses, excluded from regulatory capital calculations, might hover precariously, prone to abrupt market or consumer confidence jolts, especially in a high-interest rate environment. The narrative remains one of fragility, lurking beneath the veneer of confidence. Moody's, in their report, points out that banks are bracing for more turbulence due to the pronounced rise in the Federal Reserve's policy rate. The ongoing reduction in reserves held at the Fed and the parallel decline in deposits, thanks to the ongoing Quantitative Tightening (QT), further compound this uncertainty. As per the prognosis, interest rates are poised to remain elevated until inflation finds its way back within the Federal Reserve's comfort zone. This, coupled with the prevailing ascent of long-term US interest rates, is set to exert added strain on banks' fixed-rate assets. The financial terrain, it seems, is navigating through a maze of intertwining challenges with no clear exit. Ironically, the Federal Reserve pushed its benchmark borrowing rate to a range of 5.25%-5.5% in July. This forceful tightening of monetary policy over the past eighteen months aims to curb the soaring waves of inflation that have been sweeping through the American economic landscape. But, it seems, this soaring interest rate is inversely corroding the very fundamentals of the US financial system.

“We continue to expect a mild recession in early 2024, and given the funding strains on the U.S. banking sector, there will likely be a tightening of credit conditions and rising loan losses for U.S. banks,” Moody’s said in the report. This is a natural consequence of ill-advised increments in interest rates. With rising interest rates, there's a real chance that a recession could happen, and this might create challenges for sectors such as real estate. The agency has also cast a negative outlook for eleven key players, including Capital One, Citizens Financial, and Fifth Third Bancorp, underlining the precariousness of the current financial system. Already, some media reports are suggesting that the American banks are experiencing reduced loan demand from both businesses and consumers because of tightening credit standards. Obviously, if this weakening loan appetite persists, then the situation will further deteriorate for the small and medium-sized banks. This simply means that the US banking sector will continue to rattle with ongoing interest rate and asset-liability management perils, affecting liquidity and capital.

In June, a protracted and heated partisan clash concluded with the Biden administration narrowly averting a federal default, thwarting Congressional Republicans. The recurrent US brinkmanship over debt ceilings, paired with eleventh-hour patch-ups, has chipped away at global confidence in the nation's financial stewardship. Across the globe, investors are growing uneasy as the US national debt continues to swell, casting doubts on the credibility of the American financial system. The recent credit downgrades within a week by Fitch Ratings and Moody's, coupled with the looming possibility of a mild recession in 2024, have undeniably reinforced the notion that the primary anomaly currently facing the United States is the progressive decline in its governance.