Risks rising for banks on interest rates and credit, FDIC leader warns, despite strong financials

Risks remain on the horizon for the banking industry, the result of trends developed during the coronavirus, despite strong performance and the low number of problem banks and failures, the board chairman for the federal bank deposit insurance agency said Monday.

“Recession uncertainty, inflation, higher and changing interest rates, and structural changes in the economy associated with the increase in remote and hybrid work collectively create a lot of uncertainty for banks,” Federal Deposit Insurance Corp. (FDIC) Chairman Martin Gruenberg said. He spoke to the Institute of International Bankers meeting in Washington, D.C.

Gruenberg particularly pointed to interest rate and credit risks as key factors contributing to uncertainty. The FDIC chairman said that as a result of rising interest rates and falling values of longer-term maturity assets acquired by banks when rates were lower, most banks have some amount of unrealized losses on securities. “The total of these unrealized losses, including securities that are available for sale or held to maturity, was about $620 billion at yearend 2022,” Gruenberg said. “Unrealized losses on securities have meaningfully reduced the reported equity capital of the banking industry.”

He also cautioned bankers to watch the trends of flows in deposits “as the interest rate environment evolves.”

On credit risk, Gruenberg said that trends and uncertainties over the economic outlook – including inflation, interest rates and structural changes – will affect banks’ lending businesses too. “Depending on the business line, effects could range from fairly modest to substantial,” Gruenberg said.

He pointed to auto lending and credit cards as two areas that would be sensitive to general price inflation. “Measures of credit quality in those loan segments turned modestly worse in 2022,” Gruenberg, referring to bank performance statistics issued just last week. “Annual auto loan charge-off rates increased 83 basis points to 1.13%, and credit card charge-offs increased 87 basis points to 2.5%. It would be premature to attribute these trends to the effects of inflation, but it is reasonable to think that cash-strapped consumers could experience greater repayment difficulties as their day-to-day living expenses increase,” he said.

The FDIC board leader noted that both commercial real estate (CRE) and construction and development lending (C&D) grew at banks last year; however, he indicated that growth may be misleading. “It is important to remember though, that inflation increases the labor and materials costs that banks’ commercial borrowers expect to incur, and therefore increases loan amounts,” he said. “In real terms, the growth of CRE and C&D lending was slower. The quality of underwriting, and the timing and severity of any future recession, will likely be the key determinants of the performance of these credits.”

He also pointed to the office sector as being challenged. “As the economy navigates towards a new normal with respect to remote and hybrid work, the question is whether the need for office space has been permanently and materially reduced,” he said.

Additionally, he suggested urgent regulator scrutiny of leveraged commercial and industrial loans that could be affected by the higher interest rate environment or by in the event of a recession. He noted that “a significant amount” of the loans are sold into collateralized loan obligations (CLOs) and are ultimately held by nonbank U.S. financial firms. “Looking beyond the specifics of CLOs, I think the interconnections between banks and nonbank financial firms, and the risk exposures in times of stress, are a subject that is worthy of urgent attention by U.S. financial regulators.”

Remarks by FDIC Chairman Martin Gruenberg at the Institute of International Bankers

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