The increased stress in the U.S. banking system represents an increased risk to the U.S. sovereign rating, but at this point, it’s not expected to affect the rating, says Moody’s Investors Service.
In a new report, the rating agency said that the “rapid deterioration” in the operating environment for regional U.S. banks, over the past two weeks, translates into higher banking sector risk than it previously factored into the country’s credit rating picture.
For now, that increased risk doesn’t materially impact the other parts of the sovereign’s credit profile, Moody’s said, noting that, relative to overall GDP, the U.S. banking sector is the smallest among AAA-rated sovereigns, “which reflects the depth of financial markets in the U.S.”
However, this depth could also carry undetected risks, it noted. The U.S. banking sector is highly diversified, including some of the world’s biggest banks, but also thousands of very small institutions, Moody’s said.
“This diversity means that average financial strength can conceal pockets of higher risk for the sovereign,” it said.
For instance, a lack of transparency in areas such as private credit — which have grown quickly, but where risks are not easy to assess — poses an added challenge to policymakers. This “raises the risks that policy missteps could result in further deterioration of the credit environment,” it said.
While elevated banking sector strains are not currently a threat to the sovereign rating, that could change, if a period of “severe and prolonged stress” in the banking sector were to take hold, the report suggested. This, Moody’s added, “could weaken economic and fiscal strength.”
“In a downside scenario in which some banks’ financial stress potentially raised doubts about the sustainability of a significant part of the sector, we expect that the U.S. government would likely choose to use its balance sheet to prevent stress in individual banks from spiralling into a systemic crisis,” it said.
Additionally, Moody’s said that “severe strains on credit provision or a sustained credit crunch would materially dampen growth.”
Moreover, if a period of prolonged stress revealed weaknesses in U.S. governance and institutions, the rating agency could revise its assessment of these sovereign rating factors, it said.
“The authorities’ swift actions thus far to deal with banking sector stress are consistent with our assessment of highly effective monetary and macroeconomic policymaking,” the report said.
However, in a downside scenario, “we may reassess the quality of supervision and regulation of the banking sector,” it added.
“Policy effectiveness will be tested by policymakers’ capacity to address both inflation and financial stability risks and resolve a dilemma: efforts to anchor inflation expectations and price stability can spur financial stability risks, while measures to preserve financial stability can undercut price stability objectives,” it noted.