American banks are facing yet another quarter in which interest rates have surged, resulting in renewed concerns about shrinking margins and increasing loan losses. As the industry struggles with these challenges, some analysts are trying to find a silver lining amidst the chaos. However, the fundamental outlook for banks seems difficult in the near term, with declining revenues, margins, and growth, according to industry experts. The recent earnings season kick-off with reports from JPMorgan Chase, Citigroup, and Wells Fargo is expected to shed light on the impact of these challenges on the banking sector.
Higher interest rates are anticipated to lead to a sharp increase in losses on banks’ bond portfolios, adding to the funding pressures as institutions are forced to pay higher rates for deposits. KBW analysts Christopher McGratty and David Konrad estimate that banks’ per-share earnings decreased by 18% in the third quarter due to compressed lending margins and reduced loan demand caused by higher borrowing costs. The decline in earnings is a significant concern for the banking industry, signaling potential financial strain and difficulties in sustaining profitability. The S&P 500 Banks index has already experienced a considerable decline of 9.3% in September, largely driven by concerns over the surge in longer-term interest rates.
During the pandemic, Bank of America, an exception among big banks, encountered significant losses on bonds due to its investment in low-yielding securities. These losses have reduced the bank’s interest revenue and positioned it as the worst stock performer among the top six U.S. institutions this year. The situation highlights the vulnerability of banks to market fluctuations and the importance of making prudent investment decisions to mitigate risks.
The Varying Impact of Higher Rates
Analysts have differing views on the impact of higher interest rates on banks’ balance sheets. Morgan Stanley analysts project that the losses from the bond rout in the third quarter will be more than double the losses experienced in the second quarter. Regional lenders such as Comerica, Fifth Third Bank, and KeyBank are expected to be particularly affected by bond losses. Conversely, other analysts, such as those from KBW and UBS, suggest that certain factors could offset the capital hit for most of the industry. The duration of banks’ bond portfolios, specifically whether they own shorter or longer-term bonds, plays a crucial role in determining the impact on banks’ capital. Although the bond marks will likely remain a capital headwind, the effects may be more pronounced for a smaller group of banks based on their investment choices.
Another concern stemming from higher interest rates is the potential increase in losses in commercial real estate and industrial loans. RBC analyst Gerard Cassidy predicts that loan loss provisions will significantly rise compared to the third quarter of 2022 as banks build up reserves. This anticipated increase in loan loss provisions reflects the cautionary approach banks are taking in preparation for potential defaults and deteriorating asset quality.
While banks experience these challenges, there is also the possibility of a short squeeze during earnings season. Hedge funds have placed bets on a return of the chaos witnessed in March, which resulted in regional banks facing deposit exodus. UBS analyst Erika Najarian suggests that the combination of high short interest levels and the belief among macro investors that higher rates will drive another liquidity crisis may create a potentially volatile short squeeze in the banking sector.
On a more positive note, some banks may find stability in deposit levels during the quarter. Goldman Sachs analysts led by Richard Ramsden anticipate that banks will present stable deposit levels, which could mitigate some of the uncertainties surrounding funding pressures and liquidity risks. Additionally, guidance on net interest income in the fourth quarter and beyond may provide further support for banks. Goldman Sachs analysts express optimism about JPMorgan and Wells Fargo based on these factors.
Despite the current difficulties faced by the banking industry, some analysts believe that there may be room for a relief rally. The low expectations surrounding bank stocks, combined with their significantly beaten-down prices, create potential for a rebound. Investors are eagerly looking ahead to identify the revenue trough and project a recovery in the banking sector. While the last nine months have been arduous for the banking industry, there is hope for a turnaround as banks navigate through the challenges and potentially find opportunities for growth.
American banks are grappling with the adverse effects of surging interest rates, which have strained margins, increased loan losses, and impacted the value of bond portfolios. While challenges persist, it is crucial for banks to carefully manage their investments, focus on maintaining stable deposit levels, and explore potential opportunities for growth. By navigating these challenges strategically, banks may be able to position themselves for a recovery and future success.