Bank profits begin after another period of high interest rates and bad loans

U.S. banks are closing out another quarter in which interest rates rose, reviving concerns about shrinking margins and rising loan losses — though some analysts see a silver lining to the industry’s woes.

As happened during the regional banking crisis in March, rising interest rates are expected to lead to a jump in losses in banks’ bond portfolios and contribute to funding pressures as institutions are forced to pay higher rates for deposits.

KBW analysts Christopher McGroty and David Conrad estimate that banks’ earnings per share fell 18% in the third quarter as lending margins compressed and demand for loans declined due to higher borrowing costs.

“The fundamental outlook is difficult in the near term; revenues are declining, margins are declining, and growth is slowing,” McGroty said in a phone interview.

Earnings season begins Friday with reports from JPMorgan Chase, Citigroup and Wells Fargo.

Bank stocks have been closely intertwined with the path of borrowing costs this year. The S&P 500 banks index fell 9.3% in September on concerns raised by a surprise increase in long-term interest rates, especially the 10-year yield, which jumped 74 basis points in the quarter.

Higher yields mean the value of bonds owned by banks falls, creating unrealized losses that put pressure on capital levels. This dynamic caught mid-sized institutions, including Silicon Valley Bank and First Republic Bank, by surprise earlier this year, leading – along with a run on deposits – to a government takeover of those banks.

Big banks have largely dodged concerns associated with underwater bonds, with the notable exception of Bank of America. The bank has piled up low-yielding securities during the pandemic and incurred paper losses of more than $100 billion on bonds at the $100 billion level. Mid year. This issue limits the bank’s interest income, and made the lender the worst performing stock this year among the six largest US institutions.

Expectations varied regarding the impact of rising interest rates on banks’ balance sheets. Morgan Stanley analysts led by Betsy Grassick said in an Oct. 2 note that “the estimated impact of the bond decline in the third quarter is more than double” the losses in the second quarter.

Morgan Stanley analysts said the bond losses would have the most profound impact on regional lenders including Comerica, Fifth Third Bank and KeyBank.

However, others, including KBW and UBS analysts, said there were other factors that could mitigate the capital hit from higher interest rates for most of the industry.

“A lot will depend on the length of their books,” Conrad said in an interview, referring to whether banks hold shorter or longer-term bonds. “I think bond markers will look similar to Q4, which is still a capital headwind, but there will be a smaller group of banks that will be hurt more by what they own.”

There is also concern that higher interest rates will magnify losses on commercial real estate and industrial loans.

“We expect loan loss provisions to increase significantly compared to Q3 2022, as we expect banks to build loan loss reserves,” RBC analyst Gerard Cassidy wrote in an October 2 note.

However, bank stocks are ripe for a short squeeze during earnings season because hedge funds have bet on a return of chaos since March, when regional banks saw a mass exodus of deposits, UBS analyst Erika Najarian wrote in an Oct. 9 note.

“The combination of short interest rates above March 2023 levels and the short thesis from macro investors that higher interest rates will lead to another liquidity crisis makes us believe the sector is ripe for a potentially volatile short squeeze,” Najarian wrote.

Banks are likely to show stabilization in deposit levels this quarter, according to Goldman Sachs analysts led by Richard Ramsden. Analysts bullish on JPMorgan and Wells Fargo said that and guidance on net interest income in the fourth quarter and beyond could support some banks.

Perhaps due to the decline in banking stocks and lower expectations, the industry is expected to see a comfortable rally, McGroty said.

“People are looking at where is the bottom line in revenue?” McGarty said. “If you think about the last nine months, the first quarter was really tough. The second quarter was challenging, but not as bad, and the third quarter will still be tough, but again, it’s not going to get any worse.”