In many ways, banks reflect economic conditions. In periods of growth, lending rises and income jumps. When the economy contracts, credit demand and borrowers' ability to repay existing loans suffer. Losses for banks often follow.
Given this, it's no wonder there has been much hand-wringing in the industry over whether a downturn lurks or is even already underway. And there are certainly some signs that bankers should be worried, including U.S. gross domestic product shrinking in the first and second quarters.
To combat inflation, the Federal Reserve this year has lifted rates four times through July, with the last two hikes each 75 basis points. Those hikes marked the biggest increases since the early 1990s. When rates rise swiftly, borrowing costs spike. As a result, consumers and business owners typically delay big-ticket investments that require financing.
These rate hikes "have been large, and they've come quickly," said Fed Chairman Jerome Powell, who told reporters that another increase looms in September. "And it's likely that their full effect has not been felt by the economy."
Americans are also grappling with higher expenses inflicted by pandemic-related supply-demand imbalances and rising borrowing costs. The second-quarter GDP deceleration "is a clear indication that the economy has weakened considerably," said Eugenio Alemán, chief economist at Raymond James.
All of this leaves bankers and industry observers wondering how credit quality and loan demand will fare in the coming months. Though the vast majority of banks posted solid credit quality through the second quarter, executives were still peppered with questions by analysts about possible vulnerabilities and the likelihood banks will have to tap the brakes on growth.
"Banks need to move to a defensive stance and be prepared for anything," said Chris Nichols, director of capital markets at the $46 billion-asset SouthState Corp. in Winter Haven, Florida. "Historically, it's the loans you make before a recession that hurt you. It's time to tighten up underwriting, pull back on pricing competition and examine more often the higher risk loans you have."
Against that backdrop, here are four areas Nichols and other bankers are scrutinizing, hoping to identify and contain any emerging credit challenges.
Susceptible small businesses
Bankers have largely reported low loan losses so far this year, notably among small-business credits.
However, they concede small businesses are more vulnerable to the one-two punch of soaring inflation and rapidly rising interest rates than larger companies. Owners of small operations tend to work on narrower margins and lighter cushions for rough times. They may struggle to absorb rising costs if their customers pull back on spending in the second half of 2022.
This, in turn, will make it harder for businesses to repay existing loans.
"For a time here, we are going to have both high prices and higher borrowing costs," said Mike Matousek, head trader at U.S. Global Investors. "That's got to have an impact on the ordinary person's spending and typical small business's income."
A second-quarter survey by First Citizens Bank in Raleigh, North Carolina, found a majority of U.S. small-business owners are concerned about high costs and slowing business activity. Only 42% reported confidence in the economy this year. Similarly, just 49% were optimistic about conditions for the next two to three years.
Robert Bolton, president of the bank investor Iron Bay Capital, said that optimism is waning in areas of the country where populations are stagnant or in decline. He suspects that, should small-business loans sour in coming quarters, it would likely begin in these areas.
"When I talk with bankers all around the country, those in high-growth areas say their smaller commercial clients are still pretty upbeat. Cautious, yes, but generally positive," Bolton said. "The level of caution is more pronounced when you get away from the more vibrant cities."
Before the pandemic, analysts at Raymond James said in a report, aggregate net charge-offs for the entire banking industry were running at historically average levels. Charge-offs as a percentage of total loans in the range of mid-40 basis points to low-50 basis points throughout 2018 and 2019.
However, they said, charge-offs declined consistently over the last two years, falling to a quarterly low of 19 basis points in the third quarter of 2021 and were at 21 basis points at the end of the first quarter of this year.
The analysts cited pandemic-related government stimulus programs that supported small-business owners and consumers, in particular, as the keys to the strong credit conditions. But such support has largely wound down this year, they noted, just as costs are surging. It's a recipe for at least some credit trouble ahead.
"Once the average person gets past the summer vacations they had already planned, and they start looking at how much costs are going up relative to their means, I think that's when we start to see a real pullback in spending," said Christopher Maher, chairman and CEO of the $12 billion-asset OceanFirst Financial in Red Bank, New Jersey.
That is when small businesses could get pinched and banks would grow both increasingly skeptical of any existing small-business loans they view as risky and more conservative with underwriting of new credits, he added.
An office crisis festers
A rash of vacant office space could overwhelm the U.S. market by the end of this year. A spate of expiring leases and a shift to remote work could hamstring landlords, leaving them cash-strapped and ill-equipped to service their debts. The Federal Deposit Insurance Corp. recently said it would take a closer look at commercial real estate loans for sectors particularly hard hit by the pandemic, including loans for office space.
More than 240 million square feet of office leases — about 10% of the U.S. market — is expected to expire this year, according to data from the real estate services company Jones Lang LaSalle.
As lease agreements expire, more businesses are expected to scale back on office space, since more of their employees are working from home. Other tenants may demand lower rents, according to the data analytics firm Trepp.
What's more, soaring inflation is affecting labor and travel costs, giving companies added motivation to trim real estate expenses and leaving more landlords to wrestle with rising vacancies and falling revenue.
"The office sector has changed, no question," Maher said.
To be sure, he said, there are promising new office projects across his bank's footprint, which spans New York, New Jersey, Philadelphia, Boston and Baltimore. But vacant properties that represent vulnerabilities also dot the landscape.
"It may be three to five years before things settle down," he said.
Already, the U.S. vacancy rate across the office sector increased to an average of 12.3% in the first quarter of 2022, according to the data provider Statista. That was up from 9.6% at the start of 2020, before the pandemic.
Should office properties struggle, Maher said, it would have knock-on e ects for surrounding retailers and the bankers who lend to them. In essence, when fewer people are flowing in and out of workplaces on a daily basis, the nearby businesses that cater to that office traffic are bound to face setbacks.
Retail was already under heavy pressure before the pandemic thanks to the rise of online shopping.
"I think every bank with any exposure to these areas is watching very closely to see if and when the shoe drops on credit quality," said Jacob Thompson, managing director at Samco Capital Markets.
Short-lived recovery for hotels
Consumers are booking hotel stays at near pre-pandemic levels and business travel has regained momentum. Banks that serve the hospitality industry report sound credit conditions — marking a sharp reversal from the beating that hotels endured at the onset of coronavirus outbreaks.
Trepp data shows the delinquency rate on commercial mortgage-backed hotel sector loans fell below 7% in the first half of 2022 after reaching an all-time high of nearly 25% in June 2020 amid the height of the pandemic's first wave.
The drop in delinquency reflects a rise in hotel occupancy rates, which reached 72% in July — in line with the summer of 2019, before the pandemic, according to the hotel industry data firm STR. That compares to average U.S. national occupancy rates of around 40% at the end of 2020.
But even as vacationers return to hotels, the pandemic demonstrated that business travel is particularly vulnerable in a downturn. With the shift to remote work and the rise of virtual events, bankers say businesses could quickly pull back on travel to save money in a recession. Hotels, resorts and related businesses could suffer swift strikes to their revenue streams as a result.
And loans for hotels was another area that the FDIC would pay more attention to.
"Hospitality is always going to be a wildcard now" in the aftermath of COVID-imposed workplace changes, said SouthState's Nichols. "At a minimum, you are going to see relatively few new hotel loans. Investors want banks to protect capital and safeguard their balance sheets. They want to see this over the growth story going forward. I think that's what you see in the pressure on bank stocks."
The KBW Nasdaq Bank Index was down more than 20% through the first eight months of 2022. Of course, in a severe recession, consumers would curb vacation spending as well, dealing a fresh blow against hotels.
"I've been traveling this summer and the hotels are clearly doing just fine right now," said Michael Jamesson, a principal at the bank consulting firm Jamesson Associates. "But in the midst of a deep recession, all bets are off. We'd almost certainly see significant stress in hospitality."
Consumer vulnerabilities
GDP weakness aside, American consumers are holding strong amid a sturdy job market. The U.S. economy added 315,000 jobs in August, the Labor Department said, and the unemployment rate was just 3.7%. Average hourly earnings grew 5.2% in August from a year earlier.
The rates for credit card delinquency — a good barometer of consumer health — are low. All six major U.S. credit card issuers reported lower year-over-year annualized net loss rates in June, with the average rate hovering around 1%, according to S&P Global Market Intelligence.
"You can see how resilient the consumer is in the U.S. through the … low level of credit losses," Jane Fraser, CEO of the $2.4 trillion-asset Citigroup, said during the New York company's second-quarter earnings call in July.
Retail sales, a key measure of consumer spending, rose 0.3% in August from the prior month, demonstrating ongoing strength, the Commerce Department said.
However, as Claude A. Hanley Jr., partner at Capital Performance Group, noted, the higher spending largely reflects consumers shelling out extra cash to cover elevated costs for energy, food and other necessities.
We've felt pretty good about it. But that doesn't mean we can afford to let our guard down. In fact, we're watching everything in terms of credit quality very closely, including consumers.
While wages are up notably, they are trailing inflation by a wide margin.
"That can't go on forever," Hanley said. Credit card balances already are rising, he noted, and if that continues as interest rates surge, debt loads could become difficult to manage, particularly if a recession takes hold and impacts the job market.
During the second quarter, for example, credit card loan balances spiked 17% in April from a year earlier, the biggest jump since 1996, according to an Autonomous Research analysis of Federal Reserve data.
Banks with big consumer books, including Wells Fargo in San Francisco and JPMorgan in New York, boosted loan-loss provisions in the first half of the year, in part to prepare for potential consumer loan losses.
Smaller banks, too, are watching closely for signs of consumer stress, beginning with cards but continuing in areas such as adjustable-rate mortgages, where higher interest expenses could overburden borrowers.
Consumers themselves are bracing for harder times. The University of Michigan's Index of Consumer Sentiment produced a reading of 51.5 in July, down 37% from a year earlier.
Through the first half of 2022, "the consumer side was steady, pretty strong," said Laurie Stewart, president and CEO of the $920 million-asset Sound Community Bank in Seattle.
"We've felt pretty good about it. But that doesn't mean we can afford to let our guard down. In fact, we're watching everything in terms of credit quality very closely, including consumers."
