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U.S. Banks Face a Gathering Stagflation Storm: Starting from a Position of Strength, as Risk of Recession Rises

Since the end of the pandemic-driven recession in the U.S., inflation has increased significantly, reaching levels not seen since the early 1980s. Combined with a sharp deceleration in real economic growth, the economy appears to be entering a stagflationary period, characterized by sharply slowing growth and high inflation.

While not Fitch’s current base case, stagflation for purposes of this report refers to a period when inflation, as measured by the CPI, is elevated (greater than 4%) during a low-growth environment (GDP below 1.5%) for an extended period.

Similarities with the 1970s/1980s

Stagflationary Period
The U.S. banking industry has faced low-growth, elevated inflationary environments in the past. During stagflationary periods in the 1970s and early 1980s, earnings deteriorated, loan losses increased and capital eroded through each cycle. Similar to these prior periods, the current environment also includes supply disruptions and dramatic increases in the prices of certain commodities, particularly energy. In addition, the Federal Reserve is on an aggressive path of rate hikes, following a very accommodative period. Other similarities include geopolitical risks, with conflict in the Middle East then, and the war in Ukraine now.
Differences from the 1970s/1980s

Unlike the 1970s and early 1980s, several complicating factors make the current environment quite different. First, global economies are still addressing the residual effects of the pandemic and ongoing, related supply-chain dislocations. The Federal Reserve is also initiating quantitative tightening, which has never occurred simultaneously, at this scale, with the Fed hiking rates. Lastly, we are emerging from an extended period of quantitative easing following the Global Financial Crisis (GFC) and significant pandemic-related stimulus, which has contributed to a sharp run-up in asset prices.

As such, there is no directly comparable historical period to draw clear inferences, which results in a broad range of potential outcomes for the economy and the banking industry.

Ratings Impact Depends on Depth and Duration of Any Recession
Based on historical data comparing the make-up of the banking industry in the 1970s, the early 1980s and today, the current banking industry is in a stronger position, with higher levels of capital, liquidity and earnings. As such, the sector is much better positioned now and more resilient for a stressed macroenvironment, especially if it is short-lived. However, should rapidly tightening monetary conditions and/or geopolitical risks lead to a longer and more severe recession, more downside risk to bank ratings could arise.
2%–3% Inflation Best for U.S. Banks.

Based on overall industry performance back to 1984, U.S. banks’ optimal performance, defined as higher return on assets (ROA) and lower loan losses, occurs when inflation is between 2% and 3%.
However, Fitch’s analysis found that, when inflation exceeds 4%, it has historically corresponded to relatively weaker ROA and higher loan losses for the U.S. banking industry, as shown below.

Over the past 12 months, CPI has averaged 6.8% and reached 8.6% in May 2022. Elevated inflation can prompt broad-based selling in longduration, fixed-rate debt, which, ultimately, can have negative implications for equity and real estate markets. Financing conditions tighten and borrowing costs increase for certain borrowers, ultimately affecting bank credit quality. Fed tightening can also affect asset prices and, ultimately, economic growth. Since the beginning of the year, financial conditions have tightened, interest rates have increased, and stock and bond markets have both been negatively affected.

While recessions are not necessarily correlated with higher levels of bank failures, as most individual bank failures are due to the combination of loan concentrations and rapid growth, there is a pattern of external shocks that have contributed to a large number of bank failures in the past, including rapid declines in prices of commercial and residential real estate, oil/energy and agricultural/farmland.
The significant increase in bank failures in the 1980s is attributed to several causes, including substantial rate hikes, changes in the regulatory environment, several regional and sectoral recessions, the collapse of energy and real estate prices, and excessive risk taking on the part of the industry.

Magnitude and Frequency of Rate Hikes Changing Rapidly
The Federal Reserve has signaled its intention to combat elevated inflation through aggressive rate hikes, with its largest rate hike in 28 years, of 75bps, taken on June 15, 2022. Furthermore, since March 2022, the Federal Reserve’s economic projections have changed dramatically, with the fed funds rate currently expected to end 2022 at 3.4%, up from 1.9% in March, suggesting the possibility that further rate hikes of this magnitude may be taken.

While forward interest rates have shifted significantly recently, they are still well below levels reached during the 1980s, when short-term rates were nearly 20%. Current FOMC projections suggest rate increases that would still be meaningfully lower than the rate hikes during the mid-1970s and early 1980s.

However, the starting point for rate increases is different than during the 1970s. For example, when the Fed began hiking rates in the 1970s, the effective fed funds rate was already around 10%, compared to a zero-rate environment at the start of this tightening cycle.
While Fitch views a repeat of the magnitude of rate increases in 1979/1980 as remote, borrowers could still be adversely affected, given the relative change in rates in the current environment. However, Fitch notes that a large number of corporate and consumer borrowers took advantage of historically low interest rates over the past couple of years to refinance at low fixed rates and/or extend debt maturities, which should insulate them to some degree from sharply higher rates over the near term.

Banks Positioned for Higher Rates

Higher interest rates should theoretically benefit bank earnings, given bank balance sheets are mostly asset-sensitive right now, with bank net interest income (NII) expected to benefit from a rise in interest rates as bank assets typically reprice faster than liabilities.
For national banks, the OCC’s Spring 2022 Interest Rate Risk Statistics Report estimated that a 200-bp parallel rate shock would result in a median increase of 7% to net interest income for banks over the following 12 months, while a 300-bp shock would lead to a 10% increase in NII, or approximately $53 billion in incremental spread income (relative to 2021 levels). Banks with assets greater than $10 billion are the best positioned, with a median increase of 15% to net interest income from a 300-bp parallel shock.

However, an increase in long-term rates reduces the value of investment securities, which, in turn, can affect capital levels, while increased interest costs can adversely impact a borrower’s ability to cover its debt service costs.
While loans are not marked-to-market, the value of fixed-rate loans would also be negatively affected; conversely, the implied value of deposits increases in a higher-rate environment. However, with the continuing shift to more online banking, the magnitude and speed of recent Fed rate hikes may cause depositors to behave differently than in the past, eroding some of the embedded value of the significant deposit growth since the pandemic.

Lastly, there could be impacts to non-interest expenses from higher compensation and technology costs, while loan growth could be curbed, eroding much of the benefit to net interest income from higher rates.
The banks most vulnerable to mark-to-market capital reductions are those that have large securities portfolios with a high percentage of their securities portfolio designated as available for sale (AFS). While most banks report under the standardized approach, with no effect on regulatory capital, rising rates still affect tangible common equity and book values for all. With the 10year yield rising even further through June 2022, we expect additional unrealized losses in AOCI at quarter-end.

Unrealized Losses Build as 10-Year UST Rallies
Unrealized Gains/(Losses) on AFS (RHS)
During 1Q22, when the 10-year Treasury note rose by 80bps, the change in the tangible common equity to tangible assets ratio for the entire banking sector was a negative 56bps, the second largest decline since 1984, although Fitch attributes some of the quarterly decline to an acceleration in share repurchases and growth in risk weighted assets. The largest drop in this ratio was during 1Q20, which coincided with the onset of the pandemic and adoption of CECL.

U.S. Banks Stronger vs. the 1970s
There have been several periods of elevated inflation and low growth during the 1970s and 1980s. Earnings deteriorated, loan losses increased and capital eroded through each of these stagflationary periods.
While there were only 23 bank failures between 1973 and 1975, this period was followed by a very elevated level of failures from 1982 to 1992, during which time, nearly 1,500 banks failed. This period was characterized by dramatic Fed tightening, three separate recessions, and declines in agricultural, land and oil prices. The Fed hiked rates in the mid-1970s and to nearly 20% in the early 1980s to fight inflation that peaked at 14.6% in March and April of 1980.

Similar to the 1980s, the current environment includes supply disruptions and dramatic increases in the prices of certain commodities, particularly oil, as a result of the war in Ukraine. In addition, the Fed is on an aggressive path of rate hikes following a very accommodative period.

Based on historical data comparing the make-up of the banking industry during the 1970s, 1980s and today, the sector is currently in a stronger position, with higher levels of capital, liquidity and earnings. As such, Fitch believes U.S. banks should be more resilient to a stressed stagflationary environment.

Potential Impact of Stagflation on U.S. Banks

During the past 10 tightening cycles, a recession has followed soon thereafter eight times, with the cycles starting in February 1983 and December 1993 being the only exceptions. To the extent that the U.S. falls into a recession, weaker economic growth will also, ultimately, lead to increases in unemployment, with higher loan delinquencies and chargeoffs, a closely correlative consequence of changes in the unemployment rate, as well as initial jobless claims, which have thus far remained subdued in this cycle.

Since 1948, the average increase in the unemployment rate through a recession is 3.3% (2.7% excluding the pandemic period). Conversely, inflation typically falls during a recession, with the sole exception of the period from December 1973 to March 1975.
Assuming the unemployment rate increases 2.7% from current levels, unemployment could increase to 6.3%, which would imply a level of past-due and non-accrual levels of about 3.5%, or approximately 2.5 times the current levels.
Current Inflation Reaching Levels Seen in 1970s and 1980s

This level of non-accruals would also imply quarterly loan losses of about 1% if the historical relationship between unemployment and bank asset quality remains constant.

Bank net chargeoffs at this estimated level would be considerably higher than current levels (21bps in 1Q22) and long-term averages of about 55bps, but still very manageable for the industry. Actual loan losses will ultimately depend on the severity and duration of any recession, while higher loss provisioning may be partially offset by increased spread income as a result of higher rates. However, loan demand typically declines during a recession, which could mute some of the impact of higher rates on spread income growth.
A recession will affect borrowers to varying degrees, depending on their individual creditworthiness; however, in the aggregate, U.S. households are much less levered now (as shown in the chart below) than they were prior to the GFC, even against the backdrop of declining savings levels and increasing income inequality in the U.S.

Conversely, corporate indebtedness is at all-time highs, although absolute levels of debt payments are currently aided by still-low interest rates. Furthermore, industry leverage metrics are distorted by elevated levels of cash still on corporate balance sheets, since the pandemic.

Nonfinancial Corporate Debt at Record Highs, Interest Rates Remain Historically Low

Issuers in cyclical and energy-dependent sectors, including airlines and building materials, might be most at risk of negative rating actions under a scenario of sustained high inflation and stagnant economic growth, but there are important operational and financial considerations regarding the potential revenue and cash flow effects across all sectors.

While annual bank stress tests can provide a view into the resiliency of the largest U.S. banks to withstand various scenarios, the annual regulatory stress testing of the large U.S. banks have never included a sustained period of inflation in its “severely adverse scenarios”. This year’s stress tests include a significant drop in CPI from 8.2% at the end of 2021 to about 1.5% at the end of the scenario.
However, in 2015, under the adverse scenario, the assumptions included a nearly 300-bp increase in CPI, peaking at 4% and maintaining that level for nearly two years, while GDP peaks at 2.2% in the final quarter of the scenario.

Under this scenario, there were only moderate declines in aggregate capital ratios for the 31 participating bank holding companies (BHCs), which included high projected net interest income, driven largely by the increasing interest rates assumed under the scenario. Higher rates and wider credit spreads also contributed to negative $121 billion of other comprehensive income over the nine quarters of the planning horizon for those BHCs. Given the projected minimum capital ratios under this scenario, it is not anticipated that any the 31 participating banks would have been downgraded.

While the direct impacts to banks from a stagflationary environment may be manageable, this is not to suggest that the overall financial system will be unscathed, particularly if stagflation were to remain over an extended period. Non-bank financial intermediation, including activities conducted by investment funds, pension funds, insurance companies, finance companies and broker-dealers, among others, accounted for almost one-half (48.3%) of all global financial assets at YE20, according to the Financial Stability Board, with U.S. bank loans to non-bank financial intermediaries growing 22% in 2021, according to the Federal Reserve, well above other lending categories. Given relatively limited transparency into some components of non-bank financial intermediation, risks to the banking sector and overall financial system are difficult to fully assess and quantify.
Source: Fitch Ratings

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