By Lananh Nguyen and Juby Babu

(Reuters) – Moody’s cut credit ratings of several small to mid-sized U.S. banks on Monday and said it may downgrade some of the nation’s biggest lenders, warning that the sector’s credit strength will likely be tested by funding risks and weaker profitability.

Moody’s cut the ratings of 10 banks by one notch and placed six banking giants, including Bank of New York Mellon, US Bancorp, State Street and Truist Financial on review for potential downgrades.

“Many banks’ second-quarter results showed growing profitability pressures that will reduce their ability to generate internal capital,” Moody’s said in a note.

“This comes as a mild U.S. recession is on the horizon for early 2024 and asset quality looks set to decline, with particular risks in some banks’ commercial real estate (CRE)portfolios.”

Moody’s said elevated CRE exposures are a key risk due to high interest rates, declines in office demand as a result of remote work, and a reduction in the availability of CRE credit.

The agency also changed its outlook to negative for eleven major lenders, including Capital One, Citizens Financial and Fifth Third Bancorp.

The collapse of Silicon Valley Bank and Signature Bank earlier this year sparked a crisis of confidence in the U.S. banking sector, leading to a run on deposits at a host of regional banks despite authorities launching emergency measures to shore up confidence.

Still, Moody’s cautioned that banks with sizable unrealized losses that are not reflected in their regulatory capital ratios are vulnerable to a loss of confidence in the current high-rate environment.

The sweeping report comes against the backdrop of tightening monetary conditions after the fastest pace of interest rate increases by the Federal Reserve in decades slows demand and borrowing.

The higher rates have also raised the spectre of recession and put pressure on sectors such as real estate to adjust to post-pandemic realities.

Federal Reserve survey data released last week showed U.S. banks reported tighter credit standards and weaker loan demand from both businesses and consumers during the second quarter.

Morgan Stanley analysts said the loan demand is likely to continue to weaken, with the rate of change slowing further.

Rating agency peer Fitch has downgraded the United States by a notch to AA+ due to fiscal deterioration over the next three years and repeated down-to-the-wire debt ceiling negotiations.

The downgraded banks by Moody’s include M&T Bank, Pinnacle Financial Partners, Prosperity Bank and BOK Financial Corp.

(Reporting by Juby Babu in Bengalurua and Ankur Banerjee in Singapore; Editing by Shri Navaratnam and Stephen Coates)

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