By Lananh Nguyen and Tatiana Bautzer
NEW YORK (Reuters) - Ratings agency Moody's (NYSE:MCO) said the U.S. banking sector is still strong even after it downgraded some small- to mid-sized lenders and warned it might cut the ratings of several major banks as profits get squeezed.
"What we're doing here is recognizing some headwinds - we're not saying that the banking system is broken," Ana Arsov, managing director of financial institutions at Moody's, told Reuters in an interview.
Banks will find it harder to make money as they contend with higher interest rates, climbing funding costs and a looming recession that will weigh on profits, Arsov said. Despite the downgrades, the U.S. banking system is still among the highest rated in the world, she added.
"This is largely a profitability story - we are not raising major concerns that the system is majorly undercapitalized or underfunded," Arsov said.
An S&P index of bank stocks slid 1% after Moody's took action on 27 lenders on Monday, from cutting or reviewing its ratings or changing its outlooks to negative on some banks.
"As you look ahead, it doesn't feel like the pressure from interest rates being higher and overall monetary policy tightening is close to abating," said Jill Cetina, an associate managing director at Moody's.
The rating changes stemmed from the likelihood that bank profits will shrink in the coming quarters, Arsov said. As the economy worsens, more borrowers will fall behind on loan payments and eventually default.
Credit performance has been "stellar" in recent years, so "we only can go up in credit costs from here" in areas such as consumer loans and commercial real estate, Arsov added.
Bank profit margins will continue to be compressed as they pay higher rates to customers to retain deposits.
"We've seen funding strains in the banking sector," Cetina said. "The interest rate risk, I think, was something that the U.S. banking sector was not prepared particularly well for, and because of that, we have some challenges at certain banks."