When the largest U.S. banks report third-quarter earnings on Friday, analysts, bank customers, and other banks will be looking to see if the quality of their loan assets has deteriorated.
That’s because the continued rise in interest rates will make it harder for borrowers, including businesses, to keep current on their loans.
In addition, although the Silicon Valley Bank and Signature Bank collapses were months ago, analysts and regulators think the interest rate rise has yet to fully affect financial systems.
According to two reports on global bank financial stability this week, from the International Monetary Fund and the Financial Stability Board, vulnerabilities in the global financial system remain elevated.
So far, U.S. banks have not had to write-off significant chunks of their loan portfolios, but if interest rates stay elevated, that might change.
“The effects of the post-pandemic rise in interest rates are increasingly being felt,” said the Financial Stability Board in its October 11 annual report. “The cost of financing has risen substantially at a time when debt is at very high levels across the government, corporate, and household sectors. This will likely lead to credit quality challenges affecting both banks and non-bank investors.”
According to the IMF’s Global Financial Stability Report, also released this week, “the rise in financing costs is leading to a sharp increase in interest payments for both new and existing borrowers, including fixed-rate borrowers that need to refinance their debt.”
Corporate Borrowers
In the corporate realm, the IMF pointed out, “cash buffers of corporations are eroding as debt-service burden continues to get heftier.”
“While refinancing is not an imminent problem for the average corporation in most countries, as the tenor of outstanding debt is longer than six years, some companies need to refinance as early as next year."
Global Financial Stability Report, International Monetary Fund
The share of firms with low cash-to-interest-expense ratios has rebounded over the past two years, said the IMF.
“While refinancing is not an imminent problem for the average corporation in most countries, as the tenor of outstanding debt is longer than six years, some companies need to refinance as early as next year,” said the IMF. It estimated that global corporate refinancing needs in 2024 total more than $5 trillion, with approximately half accounted for by U.S. companies.
If the outlook on inflation turns less benign than markets anticipate, it “may cause distress in the corporate sector and test the resilience of some firms, particularly those heavily indebted.”
The four largest U.S. banks reporting earnings in the next few days — JPMorgan Chase & Co., Citigroup, Wells Fargo, and Bank of America — will post a combined $5.3 billion in third-quarter net charge-offs, the highest for that group since the second quarter of 2020, according to data compiled by Bloomberg.
“Banks have built their reserves for loan losses as they prepare for credit quality to slip from pristine levels,” pointed out Nathan Stovall, director of financial institutions research at S&P Global Market Intelligence, in an email.
However, banks face many other financial issues that could tighten lending conditions and destabilize some institutions.
Preventive Measures
Increasing unrealized losses on available-for-sale bonds due to high interest rates, as occurred at Silicon Valley Bank, could cause problems if banks need to sell assets held at book value to meet liquidity needs, said the IMF.
In addition, according to the Financial Stability Board, declines in residential and commercial real estate (CRE) prices already “could increase the probability of some borrowers defaulting and affect the quality of the collateral and of property investments held by banks. In several jurisdictions, smaller banks are more exposed to CRE than larger banks.”
While U.S. banks are generally well capitalized and have stopped the increase in deposit outflows since the Silicon Valley Bank and Signature Bank failures last March, there is more financial regulators could do to contain financial stability risks, said the IMF.
"The March 2023 banking turmoil has provided a powerful reminder that markets can shift rapidly from a balance sheet view to a mark-to-market view of risks, in which a bank’s viability is assessed based on the market value of its assets."
International Monetary Fund
For one, the IMF said adequate minimum capital and liquidity requirements, including for smaller institutions, are essential.
Two, it suggested central banks like the Federal Reserve should help enhance commercial banks’ preparedness to use eligible collateral and access central bank emergency funding facilities for banking crises.
Finally, the IMF also said that banking regulators should closely monitor banks' market metrics [as well as accounting metrics], “and to be particularly cautious regarding banks that exhibit persistent price-to-book ratios below 1.”
“The March 2023 banking turmoil has provided a powerful reminder that markets can shift rapidly from a balance sheet view to a mark-to-market view of risks, in which a bank’s viability is assessed based on the market value of its assets,” said the IMF.
