US regional bank casualties: the Fitch Ratings view

The rapid collapse of four US banks in March raised serious questions over risk management failures and regulatory blind spots. Here Christopher Wolfe, managing director, North American banks, and Olivia Perney, regional head, Western Europe and Central and Eastern European Banks at Fitch Ratings, discuss the root causes of the problems in the US – and concerns surrounding the robustness of western European institutions

What do you see as being the causes of the US regional banking issues earlier this year?

Christopher Wolfe: The problems were concentrated in a handful of banks but, when something goes wrong this badly, there is often a confluence of events.

The banks most affected – Silicon Valley Bank (SVB), Signature Bank, First Republic Bank, PacWest Bancorp and Western Alliance – had above-average industry growth in deposits. All had niche business models with concentrated deposit bases, and they were outgrowing the industry average during a period of quantitative easing. The banks then also faced increased duration risk when the interest rate environment changed – and it changed very rapidly.

Another often overlooked factor is quantitative tightening (QT). It’s not just the increase in interest rates – QT means taking a couple of trillion dollars of deposits out of the industry over a two-year horizon, so it’s going to have a big impact.

And then there were some regulatory gaps in terms of requirements for regional and mid-size banks – you don’t see the bigger banks having the same kinds of challenges.

Was Fitch aware of these challenges?

Christopher Wolfe: We had a negative outlook for US banks coming into 2023 based on fundamentals such as funding and liquidity. We were certainly aware of some of the unrealised losses that had accumulated in capital. A lot of banks had been moving securities from available for sale (AFS) to held to maturity to try and reduce some of the other comprehensive income (OCI) impact.

We had a negative outlook for US banks coming into 2023 based on fundamentals such as funding and liquidity. We were certainly aware of some of the unrealised losses that had accumulated in capital

Christopher Wolfe, Fitch Ratings

We thought deposit betas were going to increase, which feed through to margins and would put pressure on earnings. But we thought banks would have some levers to pull to offset that effect, such as access to the home loan banks and other wholesale borrowings, and even the discount window if necessary. But SVB changed a lot of our assumptions by selling its AFS portfolio outright and realising the losses. We hadn’t envisioned bank runs over a matter of hours – that was not in our forecast.

What actions did Fitch take?

Christopher Wolfe: We started canvassing our rated entities to get a picture on deposit flows and the risk of contagion. It's not as easy as it sounds because there's a lot of seasonality. There are middle-of-the-month outgoing payments for taxes and mortgages so, when this crisis is in the middle of the month, it is difficult to distil whether these are normal deposit outflows.

Signature went down that weekend. We immediately downgraded First Republic, while PacWest and Western Alliance quickly came into view.

But we were getting daily deposit runs from our rated portfolio, and assumed industry deposit levels were going to decline about two percentage points on average per quarter. We were focusing on the outliers: effectively, banks that had outflows greater than that.

What is Fitch’s outlook for US regional banks?

Christopher Wolfe: We still believe it's a negative environment for the industry. It was punctuated by some turmoil that was unique to a handful of institutions. But there was contagion effect that hit others.

What actions do you expect regulators to take now?

Christopher Wolfe: There was a regulatory gap and you will see a regulatory response. You have multiple regulatory agencies; it is a challenge to get this kind of tailoring right.

Policy-makers are not trying to put a lot of small banks out of business. At the same time, where should policy-makers draw that line? That's the big conundrum for the US.

Last year we suspected there would be tighter regulation coming in the realm of total loss-absorbing capacity requirements for category two and three banks (large regionals). Resolution options such as bail-in of debt weren’t there for the Federal Deposit Insurance Corporation in March for the failed banks. Now we suspect the new rules will be applied to a larger swathe of banks.

It’s possible the idea of excluding OCI from regulatory capital may go away – there will likely be a phase-in period.

We also expect to see better disclosure of depositor concentrations and interest rate sensitivities. And there will be some healthy debate around changes to deposit insurance, which would require Congressional action.

You’re probably talking three to five years for full implementation of regulatory tightening.

Do you foresee similar risks in the European market?

Olivia Perney: Most of the western European banks have very sound deposit franchises – there are a lot of retail and corporate banks with mostly granular deposits and 50–60% of deposits are insured.

In Europe, the regulatory environment is stricter. Even small banks are required to report their liquidity coverage ratio or net stable funding ratio, for example.

Another factor is that European banks went through the eurozone sovereign debt crisis. So they've been managing their bond holdings.

A final point in their favour is that they have ready access to central bank funding and can pledge securities, such as self-retained covered bonds.

The exception was Credit Suisse, which was the weakest link and had very specific issues, but there was no direct contagion into other banks.

Deposit development has been in line with our expectation. With QT, we expect deposits to reduce; we are seeing that and it is in line with our expectations, but again no contagion from what happened in the US.

We are not saying there is no risk in western Europe. We are looking at deposit outflows and variations in deposits, but we do not expect a significant increase on the lending side. All in all, the funding gaps remain stable and there are currently no big funding needs for the banks because there is not much lending growth.

The market has been focusing on funding and liquidity, which was previously overlooked when compared with asset quality or capital ratio concerns.

We are monitoring the situation closely. We have a deteriorating sector outlook for western European banks, but that is mainly due to three large countries with deteriorating sector outlooks: Germany, Italy and the UK. This is due more to economic slowdown than any market or deposit issue.

The main risk will come from asset quality deterioration. It's not feeding through yet but it will come under more pressure from higher interest rates, thus higher payments to service the debt and, more importantly, the expected economic slowdown.

For the latest outlooks on US and European banks, visit the Fitch Ratings website.

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