The U.S. banking system is sound and resilient, with strong capital and liquidity, according to the latest report on bank supervision and regulation released in May by the Federal Reserve Board of Governors.¹ Nevertheless, bank supervisors are actively monitoring risks associated with credit, liquidity and interest rates. These risks have risen in 2023 because of prevailing economic conditions and uncertainty about the future path of the economy.

The banking system was challenged earlier this year by the failures of three large banks (Silicon Valley Bank, Signature Bank and First Republic Bank). Even though those failures were largely triggered by concentrated funding sources and poor interest rate risk management at the institutions themselves, fear of contagion led to an anxious couple of months for depositors, investors and regulators. Of greater concern for the industry have been the effects of rising interest rates on the cost of deposits and other funding (causing costs to rise) and the fair value of investments in fixed-rate securities (causing the value to decline). Loan delinquency rates in some loan categories have begun to inch up, albeit from very low levels, leading many banks to increase the funds set aside to cover future credit losses. Higher interest rates when loans reprice means some borrowers may be challenged to make loan payments.

Funding Costs Rise

One of the most noteworthy developments in banking over the past year has been an increase in funding costs. Deposits — typically the lowest-cost liabilities — fell almost $1 trillion between April 2022 and April 2023 after a pandemic-led surge pushed them to an all-time high of $18 trillion in April 2022.

The most significant outflows have occurred at institutions with high levels of uninsured deposits. In turn, many banks have had to rely more on costlier wholesale funding — fed funds (overnight borrowing from other banks), brokered deposits, Federal Reserve facilities and Federal Home Loan Bank borrowings, for example — to meet loan demand. Rising interest rates have increased funding costs, regardless of type.

Another potential source of liquidity — the sale of investment securities held as assets — is problematic because the increase in interest rates has lowered their value; selling these assets would turn unrealized losses into realized ones.
Examiners are closely monitoring supervised banking organizations with significant underwater securities holdings and other interest rate risk exposures, conducting targeted exams as needed. Exams have been focused on deposit trends, the diversity of funding sources, the current value of investment securities and the adequacy of contingent funding plans.

Commercial Real Estate Concerns

Examiners are also paying close attention to banks with significant commercial real estate (CRE) portfolios. Concerns about credit quality typically rise when economic conditions are uncertain and interest rates are rising, but this cycle has the additional twist of a secular decline in demand for office space related to the rise in remote work. If this dip in demand leads to a downturn in property values, CRE mortgage holders may find it much harder to refinance maturing loans. Furthermore, as interest rates increase, capitalization rates tend to increase as investors expect a higher rate of return. Many properties may be unable to produce the desired rate of return, limiting investment in commercial real estate.

Since 2006, the Federal Reserve has increased its monitoring of CRE loan performance and has established expectations for expanded risk management practices for banks that are heavily concentrated in CRE. In June 2022, the Fed expanded exam procedures for banks with significant CRE concentration risk. In addition to focusing on banks’ financial condition, capital planning and risk management, examiners are taking a close look at construction and land development activities since construction lending typically accounts for a large share of losses when CRE markets deteriorate. Other loans to businesses — called commercial and industrial loans — are also under scrutiny as examiners assess the effects of rising interest rates on their performance.

Cybersecurity and Crypto-Related Risks

As noted in previous supervision reports, regulators are paying close attention to cybersecurity risks. Vulnerabilities noted in exams are being addressed, and examiners are testing banks’ preparedness for ransomware attacks and other security breaches.

Upheaval in crypto markets in late 2022 and early 2023 led to extreme deposit runoffs at banks that service the crypto industry: Silvergate Bank, an $11 billion bank with close ties to the industry, voluntarily liquidated in early 2023, and crypto-related business exposure was partially responsible for the failure of Signature Bank around the same time. In early August, the Federal Reserve released additional information about a new supervision program for banks that engage in “novel activities” related to crypto-assets and other fintech-related lines of business.

What’s Ahead

As we look ahead to the remainder of 2023, it is likely that bank funding costs will remain elevated. Recent data from the Federal Reserve’s Senior Loan Officer Opinion Survey also point to ongoing tightening in credit markets, and we’re seeing rising delinquencies on consumer loans. These data point to the need for continued vigilance by bankers and bank supervisors and highlight the importance of ensuring adequate access to contingency funding lines. Despite some positive market signals, there are still significant headwinds ahead.

1 The semiannual report covers banking conditions, as well as regulatory and supervisory developments for the institutions under the Fed’s supervisory umbrella. https://www.federalreserve.gov/publications/files/202305-supervision-and-regulation-report.pdf