US Fed judges banking system sound and resilient

In a recent Supervision and Regulation Report, the Federal Reserve has affirmed the fundamental soundness and resilience of the U.S. banking system, even in the face of stress events in March. The report underscores that banks have successfully maintained capital and liquidity ratios well above regulatory minimums, while sustaining earnings performance consistent with pre-pandemic levels, despite challenges such as pressure on net interest margins.

The report acknowledges the failures of Silicon Valley Bank, Signature Bank, and First Republic Bank, attributing them to excessive interest rate risk from long-duration assets and heavy reliance on uninsured deposits. Similar investments by other banks in fixed-rate, long-duration assets have led to significant declines in asset values as interest rates have risen.

Facing a slowdown in lending growth due to reduced demand and tighter lending standards, banks have responded by increasing provisions for credit losses. This is particularly relevant given an uptick in delinquencies related to commercial real estate and certain consumer sectors. Despite these challenges, the report notes that loan delinquency rates remain low overall.

To address issues and bank failures earlier in the year, the Federal Reserve has implemented a novel supervision program, focusing on banks involved in nontraditional financial-technology-related activities. Reflecting on measures since the Global Financial Crisis, the report highlights the doubling of capital ratios for the largest banks since 2009, attributing it to reforms aimed at bolstering the quantity and quality of bank capital. These reforms include annual supervisory stress tests and a capital surcharge for globally systemically important banks (G-SIBs).

In July, the Federal Reserve Board, along with the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC), proposed new rules to decrease future financial crisis risks. These regulations would apply to banks with assets of $100 billion or more and would replace banks’ internal credit risk estimates with a standardised measure.

The agencies have also finalised a rule updating regulations under the Community Reinvestment Act (CRA), aiming to better motivate banks to serve the needs of their entire communities, including low- and moderate-income areas.

A recent Liberty Street Economics blog post by the New York Fed highlighted vulnerabilities in the banking sector due to abrupt interest rate hikes. While gradual increases can benefit banks, immediate losses in securities portfolios could lead to funding shortages and reduced capital levels. Despite these risks, the Capital Vulnerability Index remains historically low at 1.55% of GDP.

The Federal Reserve’s October Senior Loan Officer Opinion Survey (SLOOS) detailed a tightening of lending standards and a dip in demand. These trends are largely attributed to an uncertain economic outlook and various concerns over loan quality and funding costs. Together, these insights from different Federal Reserve sources provide a comprehensive view of the current state of U.S. banking amid an environment characterised by rising interest rates and economic uncertainty.