Moody’s: U.S. Banking System Is Finally Stable

Moody’s (NYSE:MCO) announced on Tuesday that it has changed the outlook in the U.S. banking system from negative to stable. This is the first time since 2008 that the firm has changed the outlook after downgrading it in the wake of the financial crisis.

The change reflects continued improvement in the environment in which banks are operating. Following the market crash and a surge in unemployment, the U.S. economic condition at large became one of the primary risks facing banks. But downside risk begins to evaporate as economic conditions improve, and Moody’s is now forecasting 2013 and 2014 GDP growth in a range between 1.5 and 2.5 percent. On top of this, the firm expects unemployment to fall toward 7.0 percent from its current level of 7.5 percent.

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This increasingly optimistic economic outlook is shared by many economists, including many Federal Reserve board members. GDP has grown relatively slowly over the past few years — at about 2 percent annually — but most observers are expecting the rate to remain steady.

“Sustained GDP growth and improving employment conditions will help banks protect their now-stronger balance sheets,” said Sean Jones, a Moody’s Associate Managing Director and co-author of the report. “In addition, after another year of reducing credit-related costs and restoring capital, U.S. banks are now even better positioned to face any future economic downturn.”

The firm indicated that the low interest rate environment will be the single most important factor affecting bank performance over the next 12-to-18 month period. “Low rates help to promote private-sector employment growth that more than offsets government job losses,” the firm commented. “Low interest rates also have supported the recent improvements in the banks’ asset quality metrics, with net charge-offs now approaching pre-crisis levels.”

However, Moody’s also points out that the low-rate environment will reduce net interest margins, which are a key source of profitability for banks. Net interest margin is used as a metric to gauge the success of a firm’s investment decisions. Moody’s expects the low rates to reduce margins in the near and medium term.

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Testifying before Congress last week, Chairman of the Fed Ben Bernanke addressed the risks created by a long period of low interest rates. One issue that he recognized is “the possibility that very low interest rates, if maintained too long, could undermine financial stability. For example, investors or portfolio managers dissatisfied with low returns may “reach for yield” by taking on more credit risk, duration risk, or leverage. The Federal Reserve is working to address financial stability concerns through increased monitoring, a more systemic approach to supervising financial firms, and the ongoing implementation of reforms to make the financial system more resilient.”

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