Moody's Just Put These Big Banks on Notice. Here's What You Need to Know

One week ago, Moody's downgraded several regional banks. The credit ratings agency cited concerns about higher interest rates and the effect of a potential recession.

According to a survey of economists by Bankrate, there is a 59% chance of a recession before mid-2024. If we were to see a recession by then, banks could face headwinds from slower lending conditions. This also comes when regulators consider raising capital limits that could affect the largest regional banks.

Moody's put several other big regional banks on notice that they could be next to face downgrades. Read on to see the banks affected and what headwinds banks face in the near term that could weigh on their business.

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Why Moody's downgraded some regional banks

Last week, Moody's downgraded 10 small and mid-sized regional banks across the U.S., citing concerns about economic conditions which could weigh on these banks' earnings in the near term. Some of the biggest banks downgraded were M & T Bank (NYSE:MTB), Webster Financial (NYSE:WBS), and Commerce Bancshares (NASDAQ:CBSH).

To understand the downgrades, we must put it in the context of the broader economy. Inflation rose to its highest level in four decades in 2022 and 2023. The Federal Reserve uses its primary tool -- interest rates -- to bring down these inflationary pressures. Over the last 15 months, the Fed has embarked on its fastest rate-hiking cycle ever. This caught some banks off guard, such as SVB Financial's Silicon Valley Bank, which was ill-prepared and failed earlier this year.

High interest rates can be a double whammy for more vulnerable banks. If banks don't pay a competitive interest rate to customers for their deposits, those customers could go elsewhere in search of higher yields, like savings accounts or certificates of deposits.

Interest rates also have an inverse relationship with the value of bonds that banks hold. So when interest rates increase, banks' bonds and other holdings become less valuable. If deposits decline too much, banks may have to sell their loans at a significant loss, which is what happened at Silicon Valley Bank in March.

These are the biggest regional banks on downgrade watch

Moody's put six more banks under review for potential downgrades. The four largest banks on watch include:

• U.S. Bancorp (NYSE:USB) -- $581 billion in assets, 5th in the U.S.
• Truist Financial (NYSE:TFC) -- $564 billion in assets, 6th in the U.S.
• Bank of New York Mellon (NYSE:BK) -- $246 billion in assets, 11th in the U.S.
• State Street (NYSE:STT) -- $205 billion in assets, 12th in the U.S.

Banks face additional headwinds from regulators

Banks have had to face rapidly rising interest rates, but that's not their only issue. Regulators have been pushing for sweeping changes to increase capital requirements among the nation's largest banks.

In a July speech, the Fed Vice Chair for Supervision, Michael Barr, said he planned to pursue initiatives requiring banks with $100 billion or more in assets to hold more in reserves. He said that the recent failure of some regional banks reiterated the need for regulators to make the banking system more resilient.

Banks with $700 billion or more in assets are currently subject to the most stringent regulatory requirements. Lowering the threshold to banks with $100 billion or more in assets would affect numerous regional banks like U.S. Bancorp, Truist, BNY Mellon, and State Street.

In addition, in May, the Federal Deposit Insurance Corp. (FDIC) released a proposal for a special assessment to fill the Deposit Insurance Fund, applied at a rate of 12.5 basis points to each bank's uninsured deposit total during the fourth quarter of last year. According to Citigroup analyst Keith Horowitz, this assessment would reduce 2024 bank earnings by 4.5%, with State Street and BNY Mellon being the most affected by the assessment.

Approach with caution

The Fed introduced the Bank Term Funding Program in March. This program allows banks to take a loan of up to one year by pledging assets like U.S. Treasuries or U.S. agency mortgage-backed securities valued at par (not the current market value).

While this has helped alleviate some of the concerns around banks' balance sheets, banks continue dealing with the effects of higher interest rates. Not only that, but large regional banks faced increased regulatory scrutiny and potentially higher capital requirements. These banks could be forced to raise capital when earnings growth is slow, and deposits continue to shrink.

Banks face significant headwinds in the near term, and those regional banks pointed out by Moody's are some that could be the most affected by these conditions. Given the uncertainty in the economy in the near term and the effects of higher interest rates, I'd avoid those regional bank stocks for the time being.

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Citigroup is an advertising partner of The Ascent, a Motley Fool company. SVB Financial provides credit and banking services to The Motley Fool. Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Moody's and Truist Financial. The Motley Fool recommends U.S. Bancorp. The Motley Fool has a disclosure policy.