Bank stocks have experienced a downward trend due to the impact of sharply higher interest rates. However, DBRS Morningstar reports that the banking industry has reserves at their highest level in three decades.
The Federal Reserve’s indication in September that rates may remain higher for a longer period has intensified the selling pressure on bank shares. This has not only affected the stock market rally this year but has also triggered a dramatic selloff in the $25 trillion Treasury market.
According to Kathy Jones, the chief fixed-income strategist at Schwab Center for Financial Research, there are currently no obstacles preventing Treasury yields from rising further. Jones states, “It’s fairly obvious it’s not good for banks. The rise in yields has just been relentless.”
One of the consequences of higher yields on newly issued Treasury bonds is the erosion of the value of portfolios holding lower coupon debt issued during times of lower interest rates. Furthermore, banks may face challenges in refinancing large exposure to commercial property loans if rates stay elevated.
As of Tuesday, the S&P 500 index’s financial sector had declined by 5.6% for the year, and the popular Financial Select Sector SPDR ETF XLF was 5.5% lower as well.
Despite these setbacks, the banking industry’s reserve levels indicate preparedness for potential credit deterioration and increasing losses during a recession. In the second quarter, bank reserve coverage of nonperforming loans reached a three-decade high at 225%.
In a recent report, DBRS Morningstar analysts Eric Chan and Michael Driscoll stated that although credit quality has remained relatively stable since the Fed began raising interest rates in March 2022, the industry has been increasing reserves. These analysts believe that banking reforms implemented after the global financial crisis of 2007-2008 have positioned the industry to weather potential storms.
Kathy Jones from Schwab agrees with this perspective, stating, “That’s logical. They are saying: Things don’t look so great right now. I’m going to have to be more careful.”
The banking industry faces challenges as interest rates rise, but the high reserve levels and preparation for credit deterioration offer some confidence in weathering potential economic storms.
The Growing Concern of Unrealized Losses in the Banking Industry
According to the Federal Deposit Insurance Corp, banks are facing an estimated $558.4 billion of unrealized losses in the second quarter on underwater securities. This marks an 8.4% increase from the previous quarter, highlighting the growing concern within the banking industry.
Over the past few years, banks, especially regional lenders, have significantly increased their exposure to commercial real estate due to low interest rates. However, potential fallout from higher rates or a recession has caught the attention of both the Federal Reserve and the Treasury Department.
The impact of this growing concern is evident in the selloff of bank stocks throughout the year. Regional players, in particular, have experienced a more acute decline, with The SPDR S&P Regional Banking ETF KRE down about 32% so far this year, as reported by Dow Jones Market Data.
In March, Silicon Valley Bank’s collapse sparked fears of a broader banking crisis after it incurred significant losses from the sale of a large portfolio of similar securities. In response, the Federal Reserve established an emergency lending facility aimed at providing liquidity to banks and preventing forced asset sales. Although demand for this facility spiked in September, it has helped restore confidence in the banking industry.
The continuous rise in longer-dated Treasury yields has had a significant impact on U.S. bond-market returns this year. The popular iShares Core U.S. Aggregate Bond ETF AGG closed on Tuesday at its lowest level since October 2008.
Currently, yields on the 10-year Treasury are at 4.80%, while the 30-year Treasury rate stands at around 4.94% — the highest in approximately 16 years according to FactSet.
Charles Jones at Schwab suggests that the 10-year Treasury yield would require a catalyst to decrease but warns that it could climb to 5% or even 5.5% this year in a “vastly oversold” scenario.
As a result, the Dow Jones Industrial Average DJIA recently turned negative for the year, while the S&P 500 index SPX has seen its yearly gain reduced to approximately 10% from the 17% it reached in late August, according to FactSet.