US banking sector: quality assets are paramount

THE US banking industry suffered notable liquidity stress in 2023. The upheaval commenced with a run on Silicon Valley Bank in March, and set off a cascading banking crisis among regional banks in April and May.

By August, all three major rating agencies had downgraded several small to mid-sized US banks. Although large rated banks demonstrated financial resilience and favourable asset metrics, the industry as a whole only began to stabilise and rebound in the fourth quarter of 2023, prompted by the Fed’s indication of potential rate cuts.

As we enter 2024, the macroeconomic landscape that defined the sector throughout 2023 is anticipated to persist. This backdrop is characterised by sustained high inflation rates and intensified regulatory oversight.

Despite market anticipation of a mid-year policy shift, our analysis suggests that the Fed is unlikely to implement rate cuts this year. Even if a cut were to occur, it would likely be marginal. This standpoint is supported by stronger-than-expected payroll figures and a 4.1 per cent year-on-year increase in wages recorded in the US for March.

Also, the resurgence of commodity-driven inflation, propelled by military tensions and disruptions in global oil supply, reinforces this perspective.

High interest rates: tailwind for large rated banks, turmoil for regional banks

In the new paradigm of a higher-rate environment, banks are set to continue benefiting from increased interest revenue. According to the Federal Deposit Insurance Corporation (FDIC), the net interest margin (NIM) of the US banking industry stood at 3.28 per cent in Q4 2023, exceeding the pre-pandemic average of 3.25 per cent.

While the overall profitability of the industry remains robust, regional banks have shown weaknesses, with their NIM 28 basis points lower than the pre-pandemic average.

The weaker NIM of regional banks stems from their efforts to retain deposits, a challenge exacerbated by higher provision expenses and asset quality issues. In the fourth quarter of 2023, deposit costs for large rated US banks such as JPMorgan Chase & Co (JPM) and Bank of America Corp (BAC) remained stable at 2.01 per cent and 1.82 per cent, respectively.

In contrast, the regional bank New York Community Bancorp (NYCB) had to offer a higher deposit rate of 3.12 per cent. Despite paying higher deposit costs, NYCB experienced a quarterly decline of 1.6 per cent in deposits in the fourth quarter, while both BAC and JPM saw expansions of 1.5 per cent and 1.4 per cent, respectively.

Regional banks’ challenge in retaining deposits is expected to persist into 2024. Amid ongoing economic uncertainties and heightened regulatory scrutiny, capital will likely gravitate towards quality assets, allowing large rated banks to avoid substantial deposit outflows.

Additionally, in the current high interest rate environment, money market funds also emerge as an attractive alternative.

We expect loan demand growth to maintain a modest single-digit expansion in 2024, constrained by persistently high interest rates. In 2023, total loan and lease balances experienced a 1.8 per cent year-on-year increase, primarily driven by credit card and residential mortgage loans. We anticipate this trend to continue in 2024, buoyed by the resilience of the US labour market.

The market has expressed concerns regarding asset quality despite the increase in revenue. Net charge-offs rose by 0.29 per cent in Q4 2023 compared to a year prior. This is near historical averages but remains manageable. We believe loan loss reserves offer a sufficient buffer to absorb these charge-offs. US banks, especially larger ones, are well-positioned to absorb credit losses, offering reassurance amid asset quality concerns.

Higher CRE loan risks for regional banks

Meanwhile, regional and mid-sized banks grapple with heightened exposure to commercial real estate (CRE) loan risks, especially within the office sector, and face repricing risks in the multi-family portfolio.

Office property values have sharply declined due to work-from-home policies and rising office vacancies since the pandemic began. This presents a substantial challenge for US banks, given their considerable CRE debt holdings. The CRE concentration ratio, calculated as CRE loans divided by the sum of Tier 1 capital and allowance for loans and leases, remains notably higher for mid-sized banks compared to larger counterparts (see graph).

In late March, S&P Global Ratings downgraded the rating outlooks of five regional banks from stable to negative due to their elevated exposure to CRE loans, which could lead to significant deterioration in quality and performance pressures. These banks include First Commonwealth Financial Corp, M&T Bank Corp, Synovus Financial Corp, Trustmark Corp, and Valley National Bancorp.

Furthermore, as the Fed continued with quantitative tightening, it terminated the Bank Term Funding Program on Mar 11, 2024. This programme had been crucial in providing liquidity at a time when many regional banks were grappling with deposit flight.

The cessation of this programme came at an inopportune time for banks with less liquidity and weaker asset quality. With interest rates remaining high and CRE risks arising, regional banks could face significant challenges in sourcing cheaper funds and this could spark a new round of failures.

Quality matters

Amid ongoing market volatility and emerging risks in CRE portfolios, mitigating investment downside can be achieved by prioritising quality companies. Rated banks demonstrating robust asset resilience under heightened regulatory scrutiny are expected to maintain financial strength and weather the challenges.

For the US banking industry, this is an era where quality assets are paramount.

The writer is a research analyst with the research and portfolio management team of FSMOne.com, the B2C division of iFast Financial, the Singapore subsidiary of iFast Corp