Shares of the biggest banks in the U.S., including JPMorgan Chase & Co. (NYSE: JPM), Bank of America (NYSE: BAC), Citigroup Inc. (NYSE: C), Wells Fargo & Co. (NYSE: WFC) and Morgan Stanley (NYSE: MS) traded lower on August 16, continuing sector declines that began earlier in the week. 

The declines followed bond rater Fitch saying it may have to slash the credit ratings of dozens of U.S. banks. 

The rating for any given institution can’t be higher than the rating for the industry as a whole. 

Fitch analyst Chris Wolfe told CNBC earlier in the week that the agency may lower its view of the banking industry’s health. That would mean banks of all market capitalizations, such as the S&P giants, would have to be re-examined. 

Fitch, along with other agencies including Moody’s and S&P Global Ratings, base their assessments on factors including levels of debt, liquidity, and a bank’s capital level. That refers to the amount of capital it holds as a proportion of its total assets, liabilities, and risks.

Higher Borrowing Costs Could Hurt Banking Industry

If banks face higher borrowing costs, that could impede their ability to grow, or even finance ongoing operations. Banks frequently issue bonds to finance their operations, so downgrades could be very costly.

That’s because investors demand a higher return to take the greater risk of lending money to a company with a lower credit rating. Higher payments to bondholders could mean lower earnings. 

In June, Fitch lowered its rating of the “operating environment score” for banks due to regulatory problems surrounding banks, and uncertainty about where interest rates are headed.

Fitch downgraded the U.S. credit rating on August 1. Since then the S&P 500 is down 3.76%, and the Financial Select Sector SPDR Fund (NYSEARCA: XLF) is down 3.5%.

As of August 17, Fitch had not downgraded any banks.

Moody's Slashed Banks' Ratings 

Meanwhile, Moody’s slashed the ratings of 10 mid-sized banks on August 7, saying it may downgrade four larger banks. Moody’s warned that strength of banks’ credits may be vulnerable to risks associated with funding operations, and weakness in earnings. 

Moody's lowered ratings of banks including U.S. Bancorp (NYSE: USB), State Street Corp. (NYSE: STT), Northern Trust Corp. (NASDAQ: NTRS), Bank of New York Mellon Corp. (NYSE: BK), Cullen/Frost Bankers Inc. (NYSE: CFR) and Truist Financial Corp. (NYSE: TFC).

It also issued a negative outlook on Fifth Third Bancorp (NASDAQ: FITB), Capital One Financial Corp. (NYSE: COF), and Citizens Financial Group Inc. (NYSE: CFG).

Several smaller banks were also the subject of downgrades.

Bank Stocks Had Been In Recovery Mode

The negative reviews from ratings agencies mark a fairly sudden reversal of fortune after bank stocks had recovered from the upheaval in March due to regional banks. 

The SPDR S&P Bank ETF (NYSEARCA: KBE) posted strong rallies in June and July, but is now down 12.36% year-to-date, after tumbling nearly 7% in August. 

The financial sector's performance is integral to broader market performance, due to banks’ central role in the economy. Whether or not that’s popular, it’s the truth. 

A robust financial sector promotes smooth allocation of capital throughout the economy, facilitates borrowing and lending, and contributes to business expansion. Whenever a small business owner needs a loan to grow his or her business, that person turns to a financial institution. Likewise, when large public companies are doing mergers and acquisitions, or issuing debt or equity, big banks are always involved. 

Every S&P Sector Trading Lower

While downgrades could cause further harm to big banks and the financial sector as a whole, the secret has outperformed real estate, consumer discretionary, and materials in the past five days. During that time, every sector in the S&P has traded lower. 

As of August 17, the XLF ETF was finding support just at its 50-day moving average. That’s a good sign, as it means investors may be playing wait-and-see, rather than selling off in anticipation of more downgrades. But with the threat of downgrades looming, investors may want to play defense by either pocketing some profits, or cutting losses, depending on the price at which they purchased shares of financials.