Banks’ Response to Rising Rates & Liquidity Concerns

All eyes in the financial markets have been on bank performance after a series of bank failures and the liquidity crunch that followed. How have banks responded to those headwinds? Are there further issues on the horizon? During our recent thought leadership webinar, Brian Scheid, Senior Reporter for Global Markets at S&P Global Market Intelligence, asked Director of FIG Research, Nathan Stovall about the banks’ perspective and key factors fueling market trends.

Recovering from a Major Market Shock

The major storyline in the banking universe this year was the springtime collapse of Silicon Valley Bank, Signature Bank, and First Republic. Deposit outflows increased rapidly afterward, which spurred other banks to hoard cash and build deposits however they could. Brokered deposits and borrowings, primarily from the FHLB, soared in the first quarter, while deposits declined because the spread between rates offered by banks and what depositors could get in the Treasury and money markets had never been that wide.

Now that banks have defended their deposits with higher rates, outflows are expected to minimal going forward. “We think that banks will see a little bit more of their deposits leave the system in the second half of the year,” said Nathan Stovall, “but it's going to be a slow trickle as they continue to migrate these costs higher."

Even though many assume the Fed is pausing further rate hikes, deposit costs will continue to migrate higher. “Banks are going to have to continue to narrow that gap,” noted Stovall. Although this will put pressure on net interest margins and then earnings, “banks' liquidity won't be as fleeting going forward.”

Loans & Bonds

Loan growth has been better than expected despite liquidity pressures. Banks have been able to maintain modest loan growth thanks to strength in commercial and industrial lending, but institutions have approached investing in the bond market with greater caution. Stovall sees banks abiding to a theory that they’re "not going to make many new loans but will…let a lot of [their] securities book run off…and that is the way we will preserve cash."

However, loan growth could soften through the second half of the year due to the impact of higher rates being felt on the economy. Although rates started to tighten in March 2022, rates were not near current levels until late last year. “There is definitely more caution right now. However, economies [and] consumers remain pretty resilient, so they're still seeing some good opportunities to make new loans at much higher rates.”

Conversely, banks' future bond investing is likely to be more risk-averse, with greater focus on shorter duration and more liquid investments. “They own a lot of government bonds,” noted Stovall. “They own a lot of RMBS, usually [of] pretty higher credit, and muni’s. They don't tend to take much credit risk, but they did take a tremendous amount of duration risk and [the bond portfolios of] the banks that failed were significantly underwater.”

CRE Worries

Stovall indicated that commercial real estate exposures, especially in the office sector, was the area of greatest concern for most banks. He attributes this to post-pandemic operational shifts and significantly higher rates, which have made some properties less viable.

Despite the volatility, Stovall thinks commercial real estate is getting painted with a broad brush. When assessing the market, “you need to dig into the subcategories. You need to think about location, location, location. Growth doesn't necessarily cure everything, but it sure can help, and there are still a lot of people moving [to the sunbelt].”

Another key factor is whether a commercial building is owner-occupied. “A lot of commercial real estate loans might effectively be a commercial loan, but there's just commercial real estate serving as collateral to that loan so it’s [classified as] CRE. As long as the business is viable, you might not be that concerned about it.”

To hear further insights from Nathan on the U.S. economic outlook, access our complimentary, on-demand webinar.