Most bank management teams indicated that the failures were idiosyncratic and did not reflect industry-wide interest rate or liquidity risks. Financial stocks have rebounded in recent days as the worst-case scenario appears to have been averted. But we maintain our least preferred view on the sector. As evident from the results, banks are paying more to hold on to deposits, setting aside more reserves for potential loan losses in the event of a potential recession, and are now more focused on building capital rather than returning it to shareholders in the form of dividends and buybacks.


Performance a mixed bag, but no “crisis” yet

Bank first-quarter earnings have been mixed so far, with about half reporting earnings per share (EPS) beats relative to recently lowered expectations. The divergence between the largest universal banks and the midsize and smaller regional banks was evident in the results, with the former largely continuing to report higher net interest income from stronger loan growth and lower-than-expected net interest margin (NIM) compression. Meanwhile, the 50% of EPS misses were mostly attributable to lower NIM and higher loan-loss provision expense at the midsize regional banks.


While banks acknowledged the more challenging economic backdrop, they remained confident about the soundness of the overall banking system. Bank of America CEO Brian Moynihan said “crisis is too strong a word” to use in describing the current turmoil in the banking sector. Meanwhile, JPMorgan CEO Jamie Dimon said that while some tightening in credit conditions could be expected in the coming months, he wouldn’t go as far as to call it a “credit crunch,” a term that has more negative economic implications.


Nevertheless, the “crisis” did apparently cause somewhat of a flight to safety and an acceleration of deposit pricing trends that were already underway before 9 March. Despite the return of stability to the banking sector in recent weeks, we remain focused on three key risks for the sector discussed below, including interest rate risk, credit risk, and capital risk.


Rising funding costs

Let us start with the risk that kicked off the troubles in the banking sector. The rapid rise in interest rates over the past year has saddled banks with massive unrealized losses on their bond portfolios. It has also increased their cost of funding, as depositors have shifted out of non-interest-bearing accounts and have also turned to money market funds for higher yields. The market’s concern about unrealized losses on bond portfolios has ebbed somewhat as the negative impact has been shrinking, with rates declining since the Silicon Valley Bank failure. Several banks noted that these losses will not be realized (as most bonds will be held until maturity) and will decline over time as securities mature.


However, deposit trends remain in focus. In terms of deposit flows, the largest banks (JPMorgan Chase, Bank of America, and Wells Fargo) experienced deposit inflows in the quarter, reflecting a “flight to safety” following the bank failures in early March.


Meanwhile, the banks with higher proportions of commercial deposits (including some regional and trust banks) have experienced larger liquidity drawdowns and greater negative impact on net interest income as deposit costs have risen. Regional banks also saw a greater mix shift out of noninterest-bearing accounts, thereby raising deposit costs overall.


Overall, it appears that deposit betas (the rate of deposit price change relative to market rate change) are rising faster than previously expected. While the outlook for loan growth remains solid, several banks lowered their guidance for the second quarter and full year, with net interest income likely to come in lower than previously expected on the back of rising funding costs.


Credit “normalizing” but recession looms

Banks continue to see consumers in strong shape as of the end of the first quarter. Credit quality remained good with only modest deterioration in delinquencies and net charge-offs. Most management teams indicated that credit “normalization” trends continue in line with expectations.


Nevertheless, several banks increased their loan-loss provision expense to reflect a combination of higher life-of-loan portfolio losses and recent loan growth. Most acknowledged the risk of a recession on their earnings calls, and some stated their expectations for unemployment rising to 5.5–6% by late 2024.


Commercial real estate (CRE) exposure is currently a hot-button issue, and some banks provided new details about overall CRE exposure. Management teams generally expressed awareness of the risks, noting that loan-to-value (LTV) at origination are low and office-related challenges would likely play out over an extended period of time. The consensus is that the overall CRE risk should prove to be manageable.


Capital returns likely to be muted

The banking sector has adequate capital with every bank reporting ratios above their respective regulatory minimum. That said, the industry appears to be in capital build mode. Several banks have suspended share repurchases given the uncertain environment and a preference for retaining capital to support loan growth or selective M&A. Other banks expressed a willingness to continue to repurchase shares opportunistically and in consideration of macroeconomic conditions and potential regulatory changes.


What should investors do?

Estimate revisions since the bank results have been lower, but not dramatically so—since analysts had already taken down estimates and the revised guidance was only incrementally lower. However, we continue to expect guidance and estimates to trend lower in the coming quarters as deposit pricing issues become more apparent and as the economy weakens. We remain least preferred on financials. For investors looking to add exposure to US equities, our most preferred sectors are consumer staples, utilities, and industrials.


Main contributors: Solita Marcelli, Bradley Ball


Original report - Bank results: Not a crisis, but headwinds persist , 21 April, 2023.


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