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Big US lenders are in good shape to face any turmoil, but issues persist
Investment in the US

Big US lenders are in good shape to face any turmoil, but issues persist

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6 JUL, 2023

By Vontobel

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Christian Hantel, portfolio manager at Vontobel

The results of the US bank stress test are encouraging for investors. U.S. lenders have proven they have ample capital to weather any fresh turmoil in the banking sector. The impact of the most severe stress scenario resulted in losses of USD 540bn for the participating banks and as a result, Common Equity Tier 1 ratios (CET1) declined from 12.4% for the fourth quarter 2022 to 10.1% on average. While this is reassuring, it is worth nothing that results varied quite a bit among the banks. Large unrealized losses on securities portfolios, which were a big concern in spring this year, appreciated in value during the test, as interest rates were projected to decline in the stress test.

Regarding the projected losses of USD 540bn, the big part is related to loans with USD 424bn and within loans, the major drivers were credit cards, commercial and industrial loans and domestic commercial real estate loans. Not as a surprise, banks with higher exposures in these activities experienced the highest losses and hence the largest impact on their capital base. For commercial real estate, the aggregate projected loss for the banks is about USD 65bn, including a striking 20% loss rate for the office real estate market which is even above the peak loss rate observed during the Global Financial Crisis.

However, it is disappointing that only 23 banks out of the 4136 commercial banks in the US were part of the stress test. This highlights the limitations of this comprehensive exercise: a big part of the US Banking sector is just not covered by this stress test as the asset base is below the hurdle defined by the Fed. Category 1 banks, such as the globally systemically important banks (G-SIBs), fall under the strictest regulatory oversight, while category 3 to 5, where a lot of the US regional banks sit in, clearly has much less strict regulatory rules to follow and a lot of these banks are not even part of the yearly stress test.

This shortfall is likely to become more stringent in the future and the Fed is likely to tighten regulatory standards on the larger regional banks where it can, simply to reduce their incentive to grand some of the riskier loans that large banks such as the G-SIBs did not want to take on.

Investors are still aware of the turmoil of Silicon Valley Bank (SVB) and other failed banks in March. However, following the bailout of SVB by JP Morgan, clients and market participants seem to be no longer worried about the US regional banks at this stage. We see senior unsecured bonds being issued recently by US regional banks and investors obviously ready to absorb this supply. Even if these banks are required to issue at much wider spread levels than before the turmoil, the refinancing concerns have diminished.

US banking sector is robust and well equipped to weather any downturn

This was confirmed by the US banks stress results. However, some of the risks among regional banks seem more structural in nature and therefore likely to stay. This includes their sensitivity to liabilities, especially with the ongoing competition for deposits, the concentration risk regarding the business and client mix and the potential for asset quality deterioration in case a recession gets more prominent and the commercial real estate market gets pressured. The regional banks that participated in the test also passed the minimum standard but with lower stressed levels at about 6.5% to 8% CET1 ratio.

The next step is for the banks is to announce their capital requirements and their plans for capital return, based on these results, which can be announced from tomorrow onwards. To the extent that we see increased share buyback plans, we do see the potential for elevated senior bond issuance.

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