From Ukraine to inflation: Banking in a world of uncertainty

After more than two years of constant and radical adjustments to their own operations and an unstable business environment due to the COVID pandemic, 2022 was supposed to be the year when normalcy, or at least a modicum of stability, reappeared. Then Russia invaded Ukraine. In addition, the Federal Reserve launched a full-scale assault on inflation, which proved not to be just a transitory effect of the pandemic, which means banks will continue to deal with significant instability for the foreseeable future.

Ukraine and banks

The direct impact of the war in Ukraine is more severe for European banks and large multinational banks, which need to unwind and decide how to account and reserve for any losses associated with Russian operations, loans and investments. However, the broad and far-reaching sanctions imposed on Russia by broad international alliances do present challenges for the banking sector in general.

“I don’t see a lot of portfolio risk for most U.S. banks in the very near term,” says Graham Tasman, Grant Thornton’s national banking industry leader. But a major land war in Europe raises a wide variety of concerns and uncertainties. “That’s the real question — how long will the war go on? In a protracted war, risks and economic consequences accelerate rapidly and that’s more than just in the energy sector, but in commodities that drive farming and food production as well.”

Effectively managing sanctions will be another challenge. There’s no question that U.S. banks will comply with the sanctions, but difficult situations are bound to emerge. “Suppose you have a non-Russian client who is vetted in good standing with an account at a U.S. bank,” says Tasman. “You have reliable know-your-customer (KYC) practices in place, and they just happen to also have a Russian bank account, so they’re shut down. Or you have a customer who’s a distant relative of a politically exposed person. The collateral damage on customer relationships can be real and something banks are very sensitive to in going through forced compliance.”

Increased risk of cyberthreats is another potential fallout of the Ukraine crisis, given Russia’s proven capabilities in that arena.

“Operating in a highly regulated environment, banks are as well positioned as any industry when it comes to cyberthreats, but the emphasis now is on navigating an expected event, rather than just prevention,” says Tasman. “Banks are the lifeblood of commerce, so they know that if transaction-based cyberattacks are going to start, they’re going to involve banks at some level. The industry has been working to harden their defenses for over a decade, so they certainly didn’t need the Ukrainian invasion to wake them up to this threat, but it does reinvigorate the focus on recovery and resiliency. Could the Russians broaden the threat and, for example, go after the global SWIFT messaging network in retaliation? It’s possible, but SWIFT as the global messaging standard has already been through adverse scenario planning from malware-based hacks that became prominent a few years ago.”

The Fed targets inflation

Inflation was closing in on 8% by the end of February — a 40-year high. And that was before Russia invaded Ukraine, driving energy prices up further and adding considerable uncertainty to the global economic picture. In March, the Fed raised interest rates by .25%, its first rate increase since 2018. And they are just getting started. When asked recently what would prevent the Fed from imposing a 50-basis-point jump in May, Chairman Jerome Powell replied “Nothing.”

From a banking perspective, rate increases are a two-edged sword. On the one hand, higher rates mean an implied increase in net interest income. After years of near-zero interest rates, that’s a plus. On the other hand, however, demand for loans is likely to drop, so that will negatively impact growth in loan portfolios. “For most banks,” says Tasman, “the real key will be the health of the industries they are serving. That’s where we’ll see who the winners and losers are. For example, I suspect lending to the hospitality sector could grow, but commercial real estate could backslide again.”

But the Fed isn’t just raising rates. It’s also reducing its balance sheet. There’s a bias at the Fed against holding mortgage-backed securities — just holding treasuries. But the Fed accumulated a significant stockpile of mortgage-backed securities as part of its effort to support the economy during the pandemic. In order to take those securities off its balance sheet, the Fed needs buyers in the private sector, which will take time. So the initial movement will likely come from securities rolling off as they mature. That, however, happens a lot faster if people are refinancing, and refinancings are likely to slow down as rates increase.

“Fortunately,” says Tasman, “this isn’t like the financial crisis back in 2008. We’re not talking about credit default swaps or some other compounding threat — just traditional mortgage-backed securities. But that tapering is going to drive up mortgage rates because of the reduction in demand as rates increase.”

The other issue is what does the change in rates mean for current mortgage holders? For those with fixed rate mortgages, there’s limited risk and those mortgages are a solid hedge against inflation. They’ve got homes that are, at least for now, increasing in value and they have them financed at a very low rate. But some holders of variable rate loans might be pushed into difficult decisions as their house payments go up at the same time as their food costs, and energy costs are also increasing. “The good news is the underwriting standards are much better than they were before the financial crisis,” says Tasman, “so there isn’t the same level of systemic threat we saw then. But it will erode demand.”

On the other hand, climbing interest rates should help the bond market. For banks that are more full service, there could be opportunities there.

Stress tests and models

Given the degree of uncertainty banks currently face, the ability to withstand the unexpected takes on increased importance. The Federal Reserve just came out with the hypotheticals for their stress test for 2022, and, given what the world and the industry have been through in the last few years with the pandemic coupled with current issues, that test is very severe. For example, their test case has U.S. unemployment going up to 5.75% and peaking at over 10% two years out, with a 40% decline in commercial real estate prices. “That’s pretty extreme,” says Tasman, “but the whole point is to make sure that balance sheets can hold up under that sort of strain. It’s impossible to predict what acute scenarios might emerge. For banks with large global trading operations, it’s important, given the current environment, to test against possible global market shocks, and that is embedded in the latest CCAR 2022 Fed stress-test scenarios.”

Banks will also have to take a look at their current expected credit loss (CECL) models in light of evolving circumstances. “They have to retest their assumptions, understand what’s gone into those models, and do more validating to ensure that their loss projections are as reliable as they can be,” says Tasman.

ESG and transparency

ESG is also a growing concern for banks. On March 21, 2022, the SEC proposed rule amendments requiring public companies to include climate-related information in their registration statements and periodic reports. If adopted, these new rules would take effect in fiscal year 2023 and apply to SEC filings in 2024.

For banks, consideration of the potential impact of climate change is already a key concern. The financial ramifications of natural disasters are increasing at an alarming rate, impacting banks and their customers — and therefore banks’ financial results. The National Oceanic and Atmospheric Administration tracks climate and weather disasters that have caused $1 billion or more in damages and has found both the rate and severity of these events to have increased steadily over the past four decades. Adjusted for inflation, such events caused an average of $18 billion a year in damage in the 1980s. In the 2010s, that amount jumped to an average of $82.5 billion a year.

“Whether for their own disaster recovery planning, or when considering the risk profile of potential customers, geographies or industry sectors, banks have to take these risks into account in their planning and modeling,” says Tasman. “As the proposed SEC rules demonstrate, there will also be a growing compliance issue.”

Coming through the pandemic, the banking sector market landscape is rapidly changing. Financial institutions are seeking clarity and situational awareness to accelerate change, driving the need to take deliberate action. Banks, large and small, are evolving their mission, focus, and program prioritization from a historically regulatory-response strategy to a more proactive, strategic-growth agenda. For more insights into what banks are doing today to address these challenges in an atmosphere of substantial uncertainty, see our 2022 banking industry outlook.

This article is part of Grant Thornton’s quarterly Industry Intersections series, where we examine how key industries are addressing pressing trends. To read how other industries are managing global instability, visit Industry Intersections.

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