Fed policy is weighing on US banks. Here's everything to know about the Moody's downgrades.

• Moody's slashed the credit ratings on 10 US banks on Monday.
• It also put major lenders like Bank of New York Mellon and US Bancorp under review for potential downgrades.

On Monday, ratings agency Moody's lowered the credit ratings of 10 small- and mid-sized US banks by one rung, and placed a slate of larger firms under review for potential downgrades, with Bank of New York Mellon, US Bancorp, Northern Trust, and State Street among the bigger names.

Not only that, but Moody's reported a negative outlook for 11 financial firms, including Capital One, Citizens Financial, and Fifth Third Bancorp.

In what amounted to 27 rating actions on US banks, Moody's pointed to rising costs of capital, deteriorating profits, and climbing risks to assets.

Bank stocks retreated Tuesday, with the KBW Nasdaq Bank Index down almost 2%.

Behind the action is what Moody's says is a more difficult operating environment for banks amid higher interest rates, an uncertain base of deposits, and a murky outlook for the broader economy.

"To date, stress on US banks has been reflected almost exclusively in funding and interest rate risk related to monetary policy tightening, but a worsening in asset quality will likely come," Moody's wrote in a Monday report. "We continue to expect a mild recession in early 2024, and given the funding strains on the US banking sector, there will likely be a tightening of credit conditions and rising loan losses for US banks."

In effect, much of the stress on banks Moody's is responding to can be chalked up to the Federal Reserve's policy decisions over the past year and a half.

The downgrades follow 11 interest rate hikes from the Fed since March 2022, and just five months since the last bank crisis, which started with Silicon Valley Bank and ended up dragging down First Republic Bank and Signature Bank.

And it's not just banks that are feeling pain. The rapidly tightening credit environment has hamstrung plenty of non-bank businesses, with corporate debt defaults skyrocketing past last year's total in the first half of 2023.

Moody's view of the banking landscape

Through the second quarter, Moody's found banks tightened underwriting standards for commercial and consumer loans and credit cards, which made business more difficult as funding costs climbed.

Quantitative tightening, the ratings firm said, has led to a general drain on deposit funding. Even though that moderated over the last three months, systemic risks remain that could hamper deposits in coming quarters.

"Most banks' deposits were flat or down only modestly, but the mix worsened, with non-interest-bearing deposits declining and banks paying more for deposits," Moody's strategists wrote. "The resulting drop in net interest income and net interest margins eroded profitability and, thus, the ability to replenish capital internally."

They also noted that many smaller banks, like the ones they downgraded, hold comparatively low regulatory capital compared to banking giants and global peers.

The high-rate landscape, then, puts some firms with "sizable unrealized economic losses" that could eventually lead to a loss in investor confidence.

Meanwhile, small and mid-size banks with exposure to commercial real estate have seen the quality of their assets deteriorate.

"Elevated CRE exposures," Moody's said, "are a key risk given sustained high interest rates, structural declines in office demand due to remote work, and a reduction in the availability of CRE credit."

It's not just the Fed causing stress

In its report on Monday, Moody's also highlighted implications for banks of factors that aren't a direct result of Fed moves, including last year's UK gilt market chaos that pushed long-dated US Treasurys higher and weighed on banks.

With a recession still in the cards, the macroeconomic outlook in general puts pressure on the US banking sector. Funding and profitability remain more difficult than years past, and their large holdings of fixed-rate assets isn't ideal.

"Other non-Fed factors such as heavy Treasury bond issuance and spillovers from monetary policy developments in Japan are also pushing US interest rates higher," Moody's strategists said. "The 10-year Treasury yield has risen both Q3 to date and sequentially in Q2 from Q1, even as the yield curve remains inverted, deepening some banks' ALM risk and profitability pressures."

Overall, a downgrade of a company's credit rating makes borrowing more expensive. For most businesses this is a bad thing, but banks aren't like most businesses. For one, they've got a large pool of low-cost capital in the form of deposits. Even as they pay more interest on deposits this year, it's still cheap compared to borrowing in the bond market. So Moody's downgrades aren't all doom and gloom for these firms, and it's always possible the moves are reversed once the outlook turns rosier.

Michael Bell, a partner at law firm Honigman and co-chair of the group's financial arm, told Insider the downgrades shouldn't come as a surprise. Banks are in the money business, he explained, and the Fed has made money harder to come by.

"I don't believe [the downgrades] are a sign of pending doom or a sign that these are bad banks," Bell said Tuesday. "I think they are entirely reflective of the Fed moves and the overall macro economy."