Banks have a lot to worry about right now: high interest rates, rising deposit rates, slumping profitability.
Now there is one more worry: bond rating downgrades.
Banks rely heavily on the sale of bonds to help fund their operations, and ratings agencies are making it clear that those issuances could get more expensive due to a series of pressures making life more difficult for financial institutions across the country.
The first warning on bond ratings came last week when Moody’s Investors Service downgraded 10 mid-sized institutions by a single notch, warned about a review of six additional lenders and assigned a negative outlook to 11 others.
Then bank stocks dropped again on Tuesday after CNBC reported an alert from a Fitch Ratings analyst that the entire industry could be downgraded to A+ from AA-.
Such a change from Fitch would put the industry's rating below some of the country's largest banks such as JPMorgan Chase (JPM) and Bank of America, CNBC reported. Thus the credit ratings for those giant banks would need to be cut, which could trigger sweeping downward adjustments for many of their smaller rivals.
The end result is that investors will demand more return to own bonds of banks with lower ratings, thereby increasing costs for banks and putting more pressure on profits.
"We expect sponsorship from debt investors to be there, albeit at a bigger price," Morgan Stanley analyst Manan Gosalia said in a research note last week. "The risk is that this downgrade wave is persistent and continues beyond" the third quarter, Gosalia added.
Most bank stocks fell Tuesday. The KBW Nasdaq Bank Index (^BKX) fell 2.8% while the KBW Nasdaq Regional Bank Index (^KRX) fell 3.4%.
Among the country's biggest banks Bank of America (BAC) fell the most, off 3.2%. M&T Bank (MTB) was down 4.2%. Western Alliance (WAL) and Comerica (CMA) fell 4% and 4.5%, respectively.
New demands from regulators
The focus on the costs of selling bonds coincides with a campaign by regulators to pressure banks to issue more long-term debt as a way of stabilizing institutions during times of stress.
The Federal Deposit Insurance Corp., the Federal Reserve and the Office of the Comptroller of the Currency are preparing a proposal that would require banks with at least $100 billion in assets to issue enough long-term debt to absorb losses if regulators were forced to seize the institution. The FDIC, Fed, and OCC have already proposed that banks of this size hold more capital as a way of absorbing losses.
The long-term debt requirement would make it easier for banks to hold onto depositors during periods of panic, according to FDIC chair Martin Gruenberg.
"Such a long-term debt requirement bolsters financial stability in several ways," Gruenberg said in a speech Monday. "It absorbs losses before the depositor class — the FDIC and uninsured depositors — take losses. This lowers the incentive for uninsured depositors to run."
He said "we expect the proposal to provide for a reasonable timeline to meet the debt requirement and to take into account existing debt outstanding." The decision to apply it to banks with as little as $100 billion in assets was "an outcome certainly influenced by the events of earlier this year."
This spring the failures of three sizable banks that were all within the range of $100-250 billion triggered outflows across the banking system and panic that other banks could also fall. Many mid-size banks were able to lure depositors back in the second quarter by paying more for them. That increase, however, is eating into a key measure of profitability.
One bank trade group, the Bank Policy Institute, said the speech from Gruenberg didn’t include any discussion of the costs of imposing this new requirement at a time when "these banks are already facing significant deposit funding cost increases."
"With this proposal, the government will be forcing a large supply of bank debt into the market, but it’s unclear whether there is going to be sufficient demand for it, meaning this proposal could end up doing more harm than good," said Tabitha Edgens, a BPI senior vice president and senior associate general counsel.
Minneapolis Federal Reserve President Neel Kashkari said Tuesday that "banks have gotten through this reasonably well" but the risk is that if inflation is not completely under control, the Fed may have to raise rates further and banks "might face more losses than they currently face today."
Read more: What the Fed rate hike means for bank accounts, CDs, loans, and credit cards
He said he agrees with the proposal to require banks with at least $100 billion to hold more capital. "My own personal opinion is it doesn’t go far enough," he said. "I think it’s a step in the right direction, but I would like to go significantly further."
Jennifer Schonberger contributed to this report.
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