5 potential catalysts for community bank earnings in 2024

Banks' funding costs surged in the second quarter following rising interest rates and the prominent failure of two regional banks in March that were hastened in part by deposit runs. The failures amplified already elevated competition for deposits and fueled further cost increases.

That noted, there have been no major bank failures in the second half of this year, relieving nervousness among bank customers, and the Fed has not raised rates since July.

The result: While still high, the pace of funding cost increases eased significantly in the third quarter. The total cost of funds for the banking industry increased 29 basis points from the second quarter to 2.27%. That marked a substantial slowdown from jumps above 40 basis points in each of the three preceding quarters, according to the S&P Global data.  

DBRS Morningstar analyst Michael McTamney said that banks' deposit levels "continue to stabilize" and, while costs are still increasing, they are doing so at "a more moderate pace." Adverse impacts from higher funding costs could hit a trough by the end of 2023, he added.

Piper Sandler analyst Stephen Scouten said banks on the whole reported net interest margin contraction in the third quarter, but should the Fed indeed be done increasing rates, margin pressure could hit a "bottom" early in 2024.

Higher interest rates and recession fears coupled with significant inflation have curbed loan demand this year, eating into banks' ability to generate interest income. Historically, the combination of spiking rates and inflation caused economic contraction.

Yet, the U.S. has added jobs every month this year and the economy grew at a 4.9% seasonally adjusted annual rate in the third quarter, according to the Commerce Department. That was more than double the 2.1% rate of the prior quarter, subduing recession expectations.

At the same time, even with borrowing costs at the highest level in years, U.S. banks on the whole grew loans about 1% during the third quarter, according to weekly Fed data.

During earnings season in late October and early this month, several bankers said they anticipated modest loan demand through the end of this year, followed by a rebound in 2024. The thinking is that confidence in a resilient economy, alongside moderating inflation and interest rates, could give both consumers and businesses more confidence in the macro environment and, by extension, reason to borrow and invest.

Greenwood Village, Colorado-based National Bank Holdings, for example, said its loan growth through the first three quarters of this year averaged 4.8%. But Chief Financial Officer Aldis Birkans said during an earnings call that the $9.9 billion-asset bank's pipelines are "quite strong" and "we certainly look to be above 5%" for the fourth quarter, with momentum heading into next year. 

First things first: Credit costs have steadily ticked up in 2023, and bankers cautioned that more increases may lie ahead. Office properties are under pressure amid enduring remote work trends. Other pockets of the economy, such as the trucking sector, are weaker due to high costs and slower activity.

But most analysts expect loan loss increases to prove modest and manageable overall, particularly if the broader economy holds strong into next year.

Investors have worried that inflation would cause a surge in credit problems. In past cycles, elevated inflation and high interest rates hampered borrowers' ability to repay loans and credit defaults jumped. But inflation fell from 9.1% at its peak last year to nearly 3% this fall, soothing many of these concerns.

Analysts at D.A. Davidson said in a report that, "if the Fed is really done hiking rates," it would further "ease credit concerns."

Bankers addressed the credit quality outlook with their actions during the third quarter. S&P Global data showed that provisions for credit losses at U.S. banks declined in the quarter. This signaled that bankers are both confident in credit quality and that they have already built up loan-loss reserves adequately in prior quarters, the firm said.

The domestic banking industry reported aggregate provisions of $19.84 billion for the third quarter, a $2.48 billion decline from the prior quarter, according to the S&P Global data.