Against a backdrop of elevated U.S. interest rates, the country’s banking system is vulnerable in the sense that some institutions might suffer from funding pressure and weaker capital levels, the Federal Reserve Bank of New York wrote in a recent Liberty Street Economics blog post.
More than a year ago, the Federal Reserve started ratcheting up interest rates to what is now the highest level in 22 years. That, in turn, led to increases in unrealized losses on banks’ securities portfolios, which “can induce funding dry-ups and substantially weakened effective capital levels,” NY Fed staff wrote. A high-profile example: the failure of Silicon Valley Bank earlier this year, the roots of which stemmed from dislocations spurred by the high rate environment.
“The March 2023 banking crisis highlighted the vulnerability of the banking sector to a sudden rise in interest rates,” the blog authors explained. “Specifically, banks’ ability to limit the pass-through of rate-hiking cycles into deposit rates allows them to benefit from higher rates, but only gradually.”
Although risks to the banking system are rising at a modest pace, they are still trailing the levels that preceded the 2008 global financial crisis, the blog noted, citing their assessment of analytical models through Q2 2023. That’s partly because the biggest banks like JPMorgan (NYSE:JPM), Citigroup (NYSE:C) and Bank of America (NYSE:BAC) are less exposed to a shortage in capital and bank-run risks than smaller, regional lenders.
The Capital Vulnerability Index based on the 2008 crisis is sitting at around 1.55% of gross domestic product, a historically low level, the blog pointed out. Based on a scenario equivalent to the rise in interest rates in 2022, the index is “currently still somewhat elevated by recent historical standards. Such vulnerability originates from banks’ exposure to a sudden drop in the value of securities following a hypothetical further increase in interest rates.”
In the current higher-for-longer rate environment, especially amid March’s banking crisis, depositors flocked to higher-yielding alternatives, chiefly money-market funds. That’s in large part because banks have been slow to raise deposit rates, although quick to hike lending rates, as that would threaten net interest margin.
Another risk is that elevated rates would drive further deposit outflows, as well as increase losses in institutions’ securities holdings that would require more funding and weaker capital levels. Note that outflows have eased since March’s bank failures as the Fed appears to be approaching the end of its tightening campaign.
To shed more light on how the overall banking system is faring, the Fire-Sale Vulnerability Index, a hypothetical measure of banks’ vulnerability to a systemic asset fire sale, is still elevated but has pared back some of March’s climb, the blog said.
Also, the Liquidity Stress Ratio, which gauges banks’ potential liquidity shortfall under stressed conditions, has been on the rise since early last year, “driven by a shift from liquid to less liquid assets and from stable to unstable funding.” The Run Vulnerability Index has also been rising since early 2022 alongside leverage as well as illiquid assets and unstable funding.
Regional U.S. Banks: U.S. Bancorp (USB), PNC Financial (PNC), New York Community Bancorp (NYCB), Axos Financial (AX), KeyCorp (KEY), Regions Financial (RF), Huntington Bancshares (HBAN) Truist Financial (TFC), Fifth Third Bancorp (FITB) and Comerica (CMA).