As American banks close out yet another quarter marked by surging interest rates, concerns about diminishing margins and increasing loan losses are resurfacing in the industry. However, some analysts are finding a silver lining amidst the challenges.
Higher interest rates are expected to lead to an uptick in losses on banks’ bond portfolios and contribute to funding pressures, as institutions must pay higher rates for deposits. KBW analysts Christopher McGratty and David Konrad estimate that banks’ per-share earnings fell by 18% in the third quarter due to compressed lending margins and decreased loan demand resulting from higher borrowing costs.
“The fundamental outlook is hard near term; revenues are declining, margins are declining, growth is slowing,” McGratty stated in a phone interview.
Earnings season has just kicked off, with reports from major banks like JPMorgan Chase, Citigroup, and Wells Fargo. Bank stocks have been closely intertwined with the trajectory of borrowing costs throughout the year, with the S&P 500 Banks index falling by 9.3% in September, primarily due to concerns sparked by a surprising surge in longer-term interest rates, particularly the 10-year yield, which rose by 74 basis points during the quarter.
Rising yields lead to a decrease in the value of bonds held by banks, creating unrealized losses that exert pressure on capital levels. This situation took smaller institutions like Silicon Valley Bank and First Republic by surprise earlier this year, resulting in government seizure due to deposit runs.
While larger banks have largely avoided concerns related to underwater bonds, Bank of America stands as an exception. The bank heavily invested in low-yielding securities during the pandemic, accumulating over $100 billion in paper losses on bonds by midyear. This has constrained the bank’s interest revenue and made it the worst-performing stock among the top six U.S. institutions this year.
Expectations regarding the impact of higher rates on banks’ balance sheets vary. Morgan Stanley analysts led by Betsy Graseck believe that the “estimated impact from the bond rout in 3Q is more than double” the losses experienced in the second quarter.
Regional lenders, including Comerica, Fifth Third Bank, and KeyBank, are expected to be the hardest hit by bond losses, according to the Morgan Stanley analysts. Nevertheless, other analysts, such as those at KBW and UBS, suggest that other factors might mitigate the capital hit from higher rates for most of the industry.
“A lot will depend on the duration of their books,” noted Konrad in an interview, referring to whether banks own shorter or longer-term bonds. “I think the bond marks will look similar to last quarter, which is still a capital headwind, but there’ll be a smaller group of banks that are hit more because of what they own.”
There is also concern that higher interest rates will lead to ballooning losses in commercial real estate and industrial loans. RBC analyst Gerard Cassidy expects loan loss provisions to increase significantly compared to the third quarter of 2022, as banks are anticipated to build up loan loss reserves.
Despite these challenges, bank stocks may be primed for a short squeeze during earnings season, as hedge funds have wagered on a return of the chaos experienced in March, when regional banks saw a mass withdrawal of deposits. UBS analyst Erika Najarian believes that a combination of elevated short interest and a short thesis predicting another liquidity crisis could result in a potentially volatile short squeeze in the sector.
According to Goldman Sachs analysts led by Richard Ramsden, banks will likely demonstrate stability in deposit levels for the quarter. This, along with guidance on net interest income for the fourth quarter and beyond, may support some banks. These analysts express bullish sentiment toward JPMorgan and Wells Fargo.
Perhaps because bank stocks have faced significant declines and expectations are low, the industry may be due for a relief rally, according to McGratty.
“People are looking ahead to, where is the trough in revenue?” McGratty said. “If you think about the last nine months, the first quarter was really hard. The second quarter was challenging, but not as bad, and the third will be still tough, but again, not getting worse.”
