Five trends to watch in fourth-quarter bank earnings

January 6, 2023 12:51 AM

As the full-year impact of rising interest rates and inflation comes into focus, investors should expect banks to report the good, the bad and the uncertain in their fourth-quarter earnings, analysts say.

Net interest income will continue to buoy bank performance but is expected to level off as the Federal Reserve slows the pace of rate hikes in response to inflation. At the same time, if economic volatility settles down, banks could see a rebound in fee revenue from capital markets as investors trade more and seek more advice on their portfolios.

As higher deposit costs cause more outflows, bank executives could be forced to explain how they expect to compete for new sources of funding. But the negative effects of sluggish deposit growth should be mitigated by weaker loan demand amid a tightening economy – unless borrowers stampede to banks for more loans to counteract the effects of inflation.

Finally, accounting for expected credit losses and how banks manage loan-loss provisions could reveal where banks think credit quality is heading in a new downward cycle. While banks' stock-market valuations seem to be pricing in higher losses, delinquencies and charge-offs are still below pre-2019 levels.

Here's a more in-depth look at what analysts will be watching for as quarterly earnings begin to roll in next week.

Net interest income

Analysts see NII growth continuing to receive a boost from last year's rate hikes, but that may not last after the Fed signaled a slowdown in rate increases could be near.

Wedbush wrote in a note previewing fourth-quarter earnings that banks are likely to report "solid" but "moderating" NII growth and net interest margins.

NII will continue to be the "primary driver of performance" during last year's fourth quarter, according to Gerard Cassidy, an analyst at RBC Capital Markets.

Large banks are expected to report NII growth average above 30% during the quarter, he said. In 2023, if the Fed pauses rate hikes, NII will slow from an "unsustainable pace" in 2022 to "what we think will be 10% to 12%," Cassidy said.

"Net interest income growth is going to be the talk amongst investors for the quarter and the year," Cassidy said.

Fee income

With NII growth positioned to slow, fee income performance will be what determines whether banks' revenue remains relatively flat.

After certain fee-based revenue segments experienced steep declines in 2022, including in investment banking and mortgage services, analysts have mixed views about how this business group will fare in 2023.

While Wedbush analysts predicted "generally weaker" fee income during the fourth quarter of last year, contributing to a 6.8% decline in noninterest income for regional banks compared to the same period in 2021, Barclays analysts expect "more modest" bank revenue alongside similar NII growth throughout the year.

If market conditions improve, fees will likely go up as deal volume rebounds, but banks still face more permanent loss of overdraft and other consumer-facing charges that regulators are increasingly scrutinizing as "junk fees."

Cassidy, the RBC analyst, had a more optimistic projection for fees, saying that market stability and a pause in rate hikes should allow capital markets investment banking businesses in equities and debt to pick back up.

Combined total revenue - net interest and noninterest income - should "not be materially different" next year, Cassidy said, even though NII "will come down meaningfully."

"The reason being is that you're going to see fee revenues go from a negative year-over-year comparison, we think, to a positive one," Cassidy said.

Loan growth

For fee income to support revenue as NII growth slows, loan volume will become increasingly important.

Last year, as economic conditions deteriorated, consumers and businesses continued to seek bank loans. Rate-sensitive commercial real estate loan volumes held firm and commercial and industrial lending was strong, while consumers continued to open new card accounts at a strong pace.

Now, as economic turmoil looks more likely to some observers, analysts see the possibility of fewer lending opportunities - as consumer businesses feel the impact of worsening economic and heightened competition.

At Wedbush, analysts believe "peak loan growth in the current cycle could be behind us." Fourth-quarter results are likely to show loan growth at a "solid" but moderated" pace. The analysts are "particularly concerned" about the slowing pace of CRE.

Autonomous analysts noted that it typically takes around a year after the Fed begins a rate-hike cycle for loans to "begin rolling over."

Moving forward, the analysts wrote, loan growth could go two ways: either momentum builds in higher-yielding segments alongside increasing commercial utilization rates, or "cautious corporates and a weaker consumer" causes "loan growth [to] grind to a halt."

Deposits

Slower loan growth will present funding questions to banks, especially after some already began reporting deposit outflows last year, while others chose to accept higher costs for repriced rates.

The outlook from Wedbush analysts is gloomy, forecasting negative deposit growth both quarterly and year-over-year.

"While loans have been growing, deposits have been shrinking," Autonomous analysts wrote in an earnings preview note. "Depositors are waking up and starting to demand yield on their cash" as the Fed raises rates.

Chris Marinac, an analyst at Janney Montgomery Scott, is more optimistic that deposits are still "sloshing around the financial system" and that concerns about outflows are less severe than investors perceive.

"Investors are worried that bank deposits are going to come under pressure," Marinac told American Banker. "The reality is, we have seen deposits actually hang in there."

Loan-loss provisions

If the economy continues to weaken throughout 2023, the biggest question facing upcoming earnings is the need banks feel to bolster loan-loss provisions.

As credit delinquencies have remained below 2019 levels, Autonomous analysts believe an economic downturn "should be manageable."

But at the same time, the analysts said, "it's hard to be confident about the severity of a credit cycle that hasn't started."

For Barclays analysts, 2023 will bring "loan-loss normalization" if the Fed pauses rate hikes. If that scenario plays out, the analysts expect asset-sensitive business groups such as lower-end consumer and commercial real estate to be "less constructive" and areas where "loan losses will adjust the fastest."

Cassidy, the RBC Capital Markets analyst, says higher loan-loss provisions could be likely for two reasons.

One is that "it's very hard to see around corners," he said. "The forecast is saying you've got to build up reserves."

Banks could also build up their loan-loss reserves to receive a performance boost down the road.

"If you're a bank, why not assume the worst and jack up reserves in the fourth quarter?" Cassidy said. "Throw in a much bigger number than you need, then go light on provisioning next year and show better earnings growth than your peers."