Much commentary in recent months has focused on the challenges facing the banking industry’s heavyweight players, heavily exposed as they are to the impacts of geopolitics and global economic headwinds.
But in the US banking sector, it is the country’s vast network of community banks, as well as larger regional banks, that account for the overwhelming majority of the industry — more than 4000 of the US’s circa 4300 banking institutions. These institutions form the backbone of the US economy, serving millions of small and medium-sized businesses, and their fortunes therefore warrant analysis.
The US’s community banks (banks with roughly $1bn to $10bn in assets) and its 80 or so regional banks (with assets of $50bn to $250bn) may be shielded from much of these international pressures, yet the domestic picture is compromised too.
With inflation reaching historic highs, the very real prospect of significant interest rate rises and the widely discussed possibility that the Federal Reserve’s monetary tightening could tip the economy into a recession, it could be a choppy period ahead for these institutions.
Cautious optimism
However, perhaps surprisingly, many in the sector are cautiously optimistic.
Timothy Spence, president and CEO of Fifth Third Bank — an Ohio-based regional bank with a franchise spanning mid-western, southern and south-eastern states — counts himself among them, saying: “I think the outlook right now is for a technical recession, a minimum technical recession.”
whatever way this shutdown manifests itself, I think we will get through it
In a similar vein, Christopher Gorman, CEO and president of KeyBank, which has branches in 15 states, says: “I am optimistic. I think we are in for an adjustment period here … whatever way this shutdown manifests itself, I think we will get through it.”
Others, such as Calixto Garcia-Velez, CEO of Banesco USA, a community bank based in Florida, emphasise local factors in its favour. He is confident that the state is in “a unique situation”, suggesting “while the world may slow down and the US may slow down, I think we will be less adversely affected than other areas of the country.”
Well-capitalised
This is a view backed up by banking analysts, who suggest community and regional banks with investment banking operations will be able to withstand a deeper downturn in the economy.
bank balance sheets are in better shape than they have ever been
One reason for this, they suggest, is that the US banking industry is generally starting from a positive position. “Bank balance sheets are in better shape than they have ever been,” says Nathan Stovall, a principal analyst, financial institutions group research, S&P Global Market Intelligence. This strength reflects the work that banks have done bolstering capital levels and reducing risk since the 2008 crisis, as well as during the more recent Covid-19 pandemic.
Christopher McGratty, head of US bank research at investment bank Keefe, Bruyette and Woods (KBW), notes that the prospects for net interest income growth also look good, due to accelerating loan growth and expanding net interest margins. Additionally, “credit quality remains strong and capital levels are good,” he says.
Indeed, according to S&P Global Market Intelligence data, the regulatory capital — banks’ Tier 1 risk-based ratio — for all US commercial banks was almost 43.6% higher in January 2022 than during the financial crisis 15 years ago, which implies that banks now have much bigger capital buffers to endure an economic shock.
Further de-risking
The banking sector was able to reduce the reserves they had built up in 2020, to cover possible loan or credit losses during the pandemic. But in the first half of this year, with raging inflation, the risks of a looming recession and increased international uncertainty, US banks started raising their reserves again. For instance, in the first quarter of this year, KeyBank made a qualitative reserve of $50m against potential macroeconomic risks.
At an individual bank level, Fifth Third Bank and KeyBank both say they have been “de-risking” this year, in anticipation of a new recession. They have taken steps, for example, to reduce exposure in auto and specialty vehicle lending — an area, according to Mr Spence, which is an indirect asset class, offered through dealers, where the pricing is “aggressive” and the spreads are “low”.
Mr Gorman says KeyBank is withdrawing from auto lending because it is “a relationship-driven bank. And indirect auto is not a relationship product because we can’t effectively do other things for those customers.”
Loan growth
Meanwhile, in the second half of 2021 and to a lesser extent in the first six months of this year, significant loan growth has been an industry-wide trend. The growth was most significant in commercial and industrial (C&I) lending, where community banks focus on loans for small businesses and regional banks target midsize $10m to $50m companies in specific industrial sectors.
Tailwinds driving Fifth Third’s C&I loan growth have included a focus on manufacturing, the geographic strength of the south-east US market, and a trend towards not relying on global supply chains, but investing in the US, Mr Spence says.
The surge in commercial lending appears to be coming to an end, however. Widespread inflation and rising US interest rates, which increase borrowing costs, led to a decline in the pace at which US companies restocked inventories in the second quarter of 2022, according to a report from the Bureau of Economic Analysis, part of the Department of Commerce.
Further signs of a decelerating economy from April to June, according to the report, were a 13.5% decline in private investment and a big slowdown in the housing market. Altogether, gross domestic product growth for the second quarter of the year contracted at an annual rate of 0.6% — a sharp deceleration from the 6.9% growth reported in the last three months of 2021, as the economy recovered from the pandemic.
Higher rates, higher profits?
Meanwhile, some might think higher US interest rates and inflation could be positive for banks, after so many years in a low interest rate environment that hurt banks’ profit margins and made it harder for them to adequately compensate their investors.
Superficially, a rising rate environment would seem to particularly favour the net interest earnings and net interest margins of community banks, given their vanilla banking model of taking deposits and making loans. But looked at from other angles, the impact of high inflation can be quite negative.
Banks, as the principal financial intermediaries between lenders and borrowers, help tighten financial conditions by passing along the higher benchmark US funds rate, which the Federal Reserve increased from zero to a range of 2.25–2.5% by the end of July, after four rapid hikes. In this way, the US interest rate rises impact the real economy. Everything that involves rates of some kind — credit cards, mortgages, auto and student loans, banking and savings accounts — typically increases. US residential mortgage rates, which hovered around zero at the beginning of 2022, have continued to rise, reaching between 5% and 6%, leading to a dramatic decline in housing sales and a drop in home construction, according to the National Association of Realtors.
The upshot is that both residential mortgage originations and mortgage re-financings by banks, typically a staple of community and regional banks’ lending, have slumped. It is understandable that few would seek to refinance their mortgage if they obtained a mortgage at 0% or 1%, as the rates are now much higher.
For KeyBank, the housing downturn cannot be good news. A few years ago, the lender – in its biggest acquisition ever – took over Buffalo, New York-based Niagara Bank for $3.6bn. With a sizeable mortgage business and multiple retail capabilities, the investment helped balance KeyBank’s commercial and consumer businesses.
The acquisition was also important for what Mr Gorman calls KeyBank’s “targeted scale” strategy and its relationship banking perspective. KeyBank, like many other regional banks, emphasises relationship banking in order to cross-promote and sell products and services to businesses and households. It means, for instance, that commercial clients can count on one bank for loans, current accounts, lines of credit, mortgages, credit cards and all other banking needs.
But another effect of inflation on the real economy is that it also impacts the ability of borrowers to pay back their loans. While homeowners with low-rate mortgages will likely be able to withstand the impact on their finances of high inflation — particularly given average wages grew by around 5% in the year to the end of June — this is far from the case across the board. Renters and borrowers without the security of a fixed low-rate mortgage are likely to be squeezed by sharply rising costs.
Wave of deposits
On the other hand, despite a spurt in loan growth, US commercial banks still had a relatively low loan-to-deposit ratio of 59.35% as of the end of June 2022, compared to a ratio of 72.41% in 2019, according to S&P Global Market Intelligence.
This imbalance may continue for some time, as it will take a tremendous amount of loan growth to match the scale of deposits US banks have been flooded with in recent years, reflecting the major fiscal stimulus directed towards families and small businesses alike during the pandemic.
An example of this deposit bonanza is that Fifth Third Bank could afford to let about $10bn – or almost one-third of the bank’s total deposits – runoff in the second quarter of this year, rather than paying higher rates to retain them. The deposits in question were non-operational says Mr Spence, who believes the bank will be able to retain the other two-thirds of its deposits.
For a long time, US banks of all sizes have paid very low interest rates on deposits, and this has continued during this year despite the Federal Reserve’s big rate hikes. Banking analysts think such a situation cannot persist for much longer. Mr McGratty at KBW says that usually when the US benchmark federal funds rate is more than 1.5%, “that’s when deposit rates start to pick up and we are starting to see it”.
Moreover, due to competition from new online banks and the public’s increased awareness about deposit rates, banks may have to move faster in raising deposit and savings rates than they have done in the past.
Assets and liabilities mismatch
Another consideration is that is a key feature in banks’ business models is maturity transformation — banks tend to hold long-term assets and loans, while their liabilities or deposits are short term. As such, high inflation and rising rates can lead to mismatches between assets and liabilities that are harmful to banks’ balance sheet, reducing profitability and threatening stability.
This consideration is particularly acute for community banks. According to the Federal Deposit Insurance Corporation, an average of 52% of community bank assets were long term and at fixed rates in the first quarter of this year, while an average of 39% of assets were fixed rate and long term in the banking industry as a whole. So, the benefits of rising rates on net interest earnings and margins may not be so evident in the case of community banks.
Fee earnings impact
Less relevant for the smaller community banks, but more for larger regional banks, is that their non-interest (fee earnings) are also exposed to the changing fortunes of the securities and other wholesale financial markets.
Regional bankers paint a doleful picture about the dislocations in equities and bond markets this year. The vast declines in mergers and acquisitions (M&A) and initial public offering activity have been well-publicised, as have the particularly severe impact this is having on the US’s behemoth investment banks. However, regional bankers say their relationship banking model means businesses, such as credit cards, treasury management and midsize company M&A advisory, have remained fairly stable.
Mixed outlook
Despite the short-term headwinds for the US economy, some cause for optimism remains for its longer-term prospects. The outlook is mixed, with declining output but resilient job growth. The Department of Labor reported that employers added 315,000 jobs in August and the unemployment rate, though it edged up from 3.5% to 3.7% over the course of a month, is still at a record half-century low. “That doesn’t scream recession,” suggests Mr Stovall.
If a recession does occur, as many think it will, it will be an inflation-triggered recession — caused by an excess of liquidity or too much demand chasing too few goods. The historical precedents are that it will be shallower and less damaging to the economy than the recent recessions caused by credit excesses, notably the dotcom bust of 2000/01 and the 2007/09 global financial crisis.
“Given the health of consumers —who account for two-thirds of the US economy — and the low starting point for unemployment rates, the odds of this being a deep recession are not very high,” says Mr Spence.
