What next for US regional banks with rates expected to be higher for longer?

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As we commence upon earnings season, we will be paying close attention to another round of updates from the US regional banks, particularly within the context of a “higher-for-longer” rate environment. With wider adoption of a soft-landing view, as well as a higher treasury yield backdrop, we explore what implications this has for the US regional banks. More specifically, we look out for updates on bank funding costs and its impact on profitability, balance sheet holdings and asset quality, and management thoughts on the latest regulatory banking developments.
Earlier this year, US regional banks were a key source of market risk and remains a sector we continue to monitor closely.  Following the failure of three US banks, the Bank Term Funding Program (BTFP) provided a key funding and liquidity measure for US banks that provided valuable relief for many. Since March this year, the BTFP has been widely utilised – total outstanding advances under the program increased to $116bn through June, however, use of the facility has plateaued to $121bn as of the end of August, as banking conditions have normalised.
The BTFP helped restore order for the 4,000+ US regional banks at the time.  Looking forward, we re-examine the US banking sector amidst a “higher-for-longer” rate environment. Since the end of March 10-year treasury yields have increased 125bp from 3.5% to 4.7% today.  Rising rates have generally benefitted US banks in the form of higher net interest income (NII) and solid net interest margins (NIM).  

However, year-to-date, US banks have seen their funding costs rise – the cost of core deposits have repriced higher, as banks have paid higher rates amidst a competitive environment for deposits.  According to Moody’s, the median net interest margin for its sample of US banks peaked in the fourth quarter of 2022 at 3.25% and has trended lower through to the second quarter of this year to 2.92%.  In its supervision and regulation report, the Fed also noted that “increased funding costs will result in somewhat tighter net interest margins going forward”.  With the recent uptick in treasury yields, we expect some further pressure on funding costs and NIMs for US banks.
With the recent rise in long-term rates, attention will also be focused on interest rate risk as it pertains to balance sheet holdings.  Specifically, investors will be gauging the impact of higher rates on available-for-sale (AFS) and held-to-maturity (HTM) assets (such as US treasuries, mortgages, and debt securities).  As interest rates rise, the fair values of fixed-rate securities and assets will decline, resulting in unrealized losses for US banks.  Declines in the fair value of securities may impact the liquidity and capital profiles of some banks.  Additionally, we will be looking for any trends as it relates to asset quality – delinquency rates and net charge-offs (NCO) for loan books will be closely scrutinised.  While some modest deterioration is expected, we note that they will be moderating from strong starting levels. Moody’s has stated that asset quality at banks have been “unsustainably strong compared to historical pre-pandemic levels,” while the Fed commented that “net charge-offs rates remained near 15-year lows”.
Finally, we look forward to management commentary as it relates to the US banking regulatory landscape. Recently, bank regulators have issued two proposals related to Basel III Endgame (B3E) and long-term debt requirements.  Both expand the regulatory scope to include smaller banks with assets greater than $100bn.  B3E contemplates an “expanded-risk-based approach” that would provide a more standardised and consistent regulatory framework and would entail compliance with supplementary leverage ratio and countercyclical capital buffer requirements. Additionally, a separate proposal calls for large banks to maintain a minimum amount of “eligible long-term debt” to potentially “absorb losses” and “increase options to resolve” a failed bank. For both proposals, comments are due in Nov-23 with phased-in compliance beginning in 2025.  We look for further clarity on how these measures will impact the liquidity and capital profiles of US banks.
In conclusion, regional banks could still provide us with plenty of headlines in the upcoming earnings season. We doubt that March’s turmoil was the last chapter in this story as some of the issues that caused it have gotten worse. Namely, mark-to-market losses on UST holdings and profitability pressures. What remains an open question is whether the issues in the sector will be large enough to cause macro instability or remain more of a micro concern. The earnings season will certainly help answer the question.




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