The banking industry currently is facing a host of issues, including high interest rates, waning loan demand, rise in deposit costs and worsening asset quality. Now, adding fuel to the fire, they need to worry about ratings downgrade.

In an exclusive interview with CNBC on Tuesday, Fitch Ratings analyst Chris Wolfe said that though slashing of the banking industry’s ratings to AA- from AA in June didn’t lead to ratings downgrades for banks, another one-notch downgrade in the industry ratings to A+ will result in the recalibration of “all our financial measures and would probably translate into negative rating actions.”

Such an action will place industry’s ratings below those of Wall Street giants like JPMorgan JPM and Bank of America BAC. Thus, the credit ratings of these large lenders will be cut, leading to a cascading effect as smaller banks’ ratings will have to be adjusted as well.

The development led to bearish investor sentiments as it raised issues related to the health of the banking industry. All the major indexes ended in red yesterday. The KBW Nasdaq Bank Index lost 2.8%, while the KBW Nasdaq Regional Bank Index declined 3.4%. Also, the S&P 500 Banks (industry group) Index was down 2.8%.

Among the banks, BAC declined 3.2%, while JPM fell 2.6%. Also, several smaller regional banks (that bore the brunt of the industry-wide turmoil in March), like Comerica CMA, Western Alliance Bancorporation WAL and KeyCorp KEY, were down 4.5%, 4.1% and 3.5%, respectively.

The industry is already reeling from Moody’s actions on several small and large financial institutions. Last week, it cut the ratings of 10 small-to-mid-sized institutions, placed six bigger lenders under review for potential downgrades and lowered its outlook to negative for 11 other banks.

While noting that downgrades are not certain, Wolfe stated that the risks are real.

The major factor that is likely to push Fitch to slash the industry ratings is the path of the interest rates that will be decided by the Federal Reserve. Though several market participants are of the opinion that the rate hikes are done for now, and the central bank might cut rates next year, this isn’t an inevitable conclusion. Higher rates for longer periods will put a strain on banks’ profitability.

Another major aspect is loan default rates. Delinquencies rise in high interest rate regimes and the Fitch has already raised concerns on the impact of commercial loan defaults on smaller lenders. Wolfe noted, “That shouldn’t be shocking or alarming. But if we’re exceeding [normalized losses], that’s what maybe tips us over.”

As the banks depend heavily on bonds to fund their operations and rating agencies are warning of these sources getting expensive, it will become all the more difficult for banking institutions to sustain profitability.

At present, JPMorgan sports a Zacks Rank #1 (Strong Buy) while both BAC and WAL have a Zacks Rank of 3 (Hold). On the other hand, CMA and KEY carry a Zacks Rank #5 (Strong Sell).
Bank of America Corporation (BAC): Free Stock Analysis Report

JPMorgan Chase & Co. (JPM): Free Stock Analysis Report

Comerica Incorporated (CMA): Free Stock Analysis Report

KeyCorp (KEY): Free Stock Analysis Report

Western Alliance Bancorporation (WAL): Free Stock Analysis Report

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