U.S. banking sector stress poses downside risk

Heightened stress in the U.S. banking system has increased uncertainty in the economic outlook, says Moody’s Investors Service, and, while its forecast remains unchanged, downside risks have increased.

In a new report, the rating agency said the first quarter confirmed its expectation that the higher rate environment, resulting in weaker economic growth, will be the primary driver of credit trends this year, and that tighter financial conditions can spark unexpected events.

“The stress experienced by some mid-sized U.S. regional banks serves as a reminder that a turn in the rate cycle can trigger otherwise latent risks,” Moody’s said.

While the action by regulators to contain that stress and prevent broader contagion has seemingly succeeded at averting systemic risk, the underlying stress will likely add to the ongoing tightening of financial conditions, it noted.

“But as long as systemic risks moderate, the additional negative impact on GDP growth will likely be modest,” it said.

Moody’s baseline forecast is for U.S. real GDP growth to weaken to 0.9% in 2023, before ticking up to 1.1% in 2024.

It also foresees a 25-basis-point rate hike in May and the possibility of another hike in June, with the U.S. Federal Reserve Board not starting to back off until 2024.

Yet, the increase in bank stress has “added uncertainty to the outlook,” it cautioned.

For instance, if asset quality declines more than expected, and credit losses surge, this could reveal “new vulnerabilities built up over the past several years of search for yield amid low interest rates,” it said.

Moreover, large sectors of the economy, such as commercial real estate, are facing increased uncertainty in the wake of the pandemic.

“If risks crystallize in multiple pockets, the ultimate losses on balance sheets of financial firms could be substantial and potentially become a source of financial stability risk,” it said.

While it’s expected that regulators will try to combat any new stresses that arise, Moody’s warned that these events can exceed regulators’ capacity to curb systemic risks.

“We are cognizant that risks typically materialize in unexpected places and play out in nonlinear ways, especially if they spread and migrate from one sector to another despite the best efforts of policy-makers and regulators,” it said.

As a result, it expects financial markets to remain volatile in the months ahead.

“More bank failures or larger valuation losses if yields increase even further could trigger bank runs and loss of bank investor confidence that may be difficult for federal authorities to contain,” it said.

These kinds of balance sheet pressures in the financial sector could also spillover to the real economy, specifically in “liquidity, interest rate and confidence sensitive sectors,” which could be harmed by declines in credit provisioning, it noted.

In a moderate downside scenario, Moody’s said it would expect the U.S. economy to enter a recession in the second quarter, with annual GDP coming in at just 0.5% this year and 0.1% in 2024.

A more severe negative scenario — while unlikely — could feature a credit crunch “similar to the global financial crisis,” which results in real GDP dropping by 0.9% this year and 2.1% next year.