What's weighing down bank stocks — and likely to keep doing so

Bank stocks, under pressure through much of 2023, are once again losing ground, hampered by fresh credit quality concerns and fallout from stubbornly high interest rates.

The KBW Nasdaq Bank Index came in at a reading of 98.0 at the close of Jan. 30. A week later, the index had slipped 5%, to 93.44 on Tuesday. That was off less than 1% from Monday's close but down nearly 20% from the previous 52-week high.

The index's decline continued into Wednesday morning trading. 

In that space of time, the $116 billion-asset New York Community Bancorp on Jan. 31 posted a fourth-quarter loss, cut its dividend by 70% to shore up capital and moved to build up its reserve for loan losses. Its stock dropped more than 37% that day.

It punctuated simmering worries about vulnerabilities in the banking system and sent ripples across the industry's publicly traded companies.

Interest rates that spiked in 2022 and last year — driven by Federal Reserve policy to tame inflation in the pandemic's wake — created a host of challenges for banks big and small. That included a surge in deposit costs, curbed loan demand amid high borrowing costs and increased potential for credit losses. When borrowers with floating-rate loans such as credit cards have in the past seen their debt costs jump, more of them struggled to make their payments.

New York Community attributed its losses to challenges in commercial real estate portfolios, particularly loans tied to the office sector and multifamily loans, analysts Sumit Grover and Benqing Shen of Trepp, a CRE data firm, noted in a report. Urban office property owners are grappling with elevated vacancy rates imposed by enduring remote work trends. Additionally, apartment buildings once filled with residents living close to their workplaces are losing tenants.

While the overall CRE allowance level for loan losses — relative to total loans — remained steady at around 2.3% at the end of 2023, office loan allowances have increased significantly over the last four quarters, rising to 4.4% from 1.6%. The ratio for multifamily loans reached 2.9%, the Trepp analysts said.

"This reflects the realization that office loans, and to some degree multifamily loans, are starting to weigh on banks' portfolio performance," they wrote. "Trepp projects more charge-offs and losses in those sectors in the next few quarters."

Also last week, coinciding with New York Community's earnings results, Fed policymakers chose to leave interest rates at elevated levels and signaled that this could continue until at least May. Inflation has cooled from a 40-year peak of 9.1% in 2022 and declined to 3.4% at the end of last year. Yet Fed Chair Jerome Powell cautioned at a news conference that it was unlikely he and his colleagues would lower rates at their next meeting in March, as bankers entered 2024 hoping to see. The Fed would then meet again in May.

The Fed lifted rates at the fastest pace in four decades between March 2022 and July 2023, to a range of 5.25% and 5.5%. It has kept its target rate at that level since.  

At issue: The economy grew through both the third and fourth quarters of last year, powered by a strong job market. The Atlanta Fed forecasted 4.2% growth for the current quarter following a government report that showed January employment expansion of 353,000 jobs. The unemployment rate last month held steady at 3.7%, near a 40-year low.

The economic vigor keeps inflationary pressure alive, and Fed policymakers are wary of rate reductions as a result. While Powell left cuts on the table for later this year, the recent run of strong economic data likely delays cuts and "reduces" the number of rate declines this year, said Damian McIntyre, portfolio manager at Federated Hermes.

Elevated rates have driven up deposit costs for banks and, at the same time, slowed loan demand. That combination hurt banks' profitability in the second half of 2023, as net interest income slumped.

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Equally concerning, analysts said, more banks reported increased credit losses. Most characterized these hits as isolated and overall loan losses across the industry remain low. But analysts say that, even with economic resiliency, high rates deep into 2024 could spur more pain for borrowers. Inflation, which still hovers well above the 2% rate that the Fed says is healthy, also creates problems. This is true in CRE but also in consumer categories.

Raymond James analysts Drew O'Neil and Doug Drabik, for example, noted that credit card delinquency rates have climbed steadily since the middle of 2023.

"Since hitting a 17-year low amid the 2021 pandemic, 90-plus day delinquencies are up 83%," they wrote in a research report. "Delinquencies have maintained or increased in 23 of 28 months reported after the low in August 2021."

The Raymond James analysts explained why in simple terms.

"Although inflation is off its highs, it is still higher than desired. A falling inflation number does not mean prices are cheaper. It means that prices are not increasing at as fast a pace, yet they are still increasing. Also, the prices that did increase during the worst of the inflationary period are still high," they wrote in the report.

While consumer earnings have climbed over the past year, they have not kept up with inflation, the analysts added. For instance, "if a gallon of milk went from $2.00 to $3.50, and inflation is falling, it may cost $3.52 or so under falling inflation, but not back to the $2.00 amount. So whether you believe inflation is going down or stagnating, things just cost more today. Wages have not kept pace, the cost of goods and services is up, and consumer debt has risen. This formula does not work forever."