Will a 'soft landing' fuel 1990s-like boom for banks?

Banks had a bumpier ride than expected last year, but many analysts see brighter times ahead for the industry as the Federal Reserve weighs interest rate cuts. 

High interest rates were a major factor behind banks' troubles in 2023, as they were forced to pay depositors higher rates and turn to more expensive funding backstops during last spring's banking crisis.

Bankers expect some lingering pain this year from what proved to be a year of heavy deposit competition. But if deposits were the major issue in 2023, the health of bank borrowers is expected to define how well the industry fares in 2024. 

What's certain is some borrowers are likely to default on their loans. High interest rates, lower cash buffers and perhaps slowing demand has made it a bit harder for bank customers to repay their obligations. Credit card charge-offs are back near their pre-pandemic levels, commercial borrowers are beginning to see stress and worries remain over banks' commercial real estate loans. 

But the U.S. economy has consistently defied recession forecasts, making it more likely that loan defaults will stay contained. Markets are increasingly optimistic that the Fed can achieve an elusive "soft landing," where a rate hike cycle doesn't end up crashing the economy. The last time that happened: the mid-1990s under then-Fed Chairman Alan Greenspan. 

Bank stocks boomed in 1995 as the economy remained on track — and banks' loan books remained healthy, unlike in the recessions of 2001 and 2008. 

Gerard Cassidy, an RBC Capital Markets analyst, wrote in a note to clients that he expects some bank loans to go sour this year but that the deterioration should be "quite gradual and manageable." 

"As investors become more comfortable with the credit outlook as banks successfully manage through it, we believe the banks should be able to outperform the broader market similar to 1995," Cassidy wrote. 

Bank stocks rallied last month over that optimism, but a few analysts are a bit more skeptical. Banks were a major beneficiary of the mid-1990s boom, which fueled strong loan growth of 7%, wrote Erika Najarian, an analyst at UBS. But today, the rise in nonbank lenders means banks will have a smaller role, she wrote, and the effects of a decade of ultra-low rates followed by rapid rate hikes remain unclear.

"We are unsure that the pre-conditions for a soft landing are as strong as they were in the mid-'90s," Najarian wrote in a note to clients.

Soft landing or not, here are some key trends to watch in bank earnings this year.

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Credit quality

Consumers and businesses' balance sheets were in solid shape for much of the past three years. But now banks' loan quality is "normalizing" to pre-pandemic levels, threatening to lower bank profits as lenders charge off bad loans and bump up their reserves.

The stress showed up first in consumers, whose budgets had been helped by pandemic-era stimulus funds and increased savings. As that buffer dwindled, those with lower incomes and credit scores had a tougher time repaying their credit cards and auto loans. Consumer charge-offs now have neared or exceeded pre-pandemic levels at many lenders.

They've also started to tick up recently among banks' commercial borrowers, as companies in weaker positions close up shop. Outside of the trucking sector, bankers don't see major stresses on their portfolios. Instead, they've described the charge-offs they've seen so far as "one-offs." 

One major question facing banks is whether commercial real estate loans, particularly those for office buildings, will start to go sour as some come up for refinancing at higher rates. Multifamily CRE has also come under focus, partly due to an oversupply of apartments in some cities and buildings' ability to stay current on loans since financing costs are high.

Still, wrote Truist Securities analyst Brandon King, the risks "have been diminished with the likely peak in rates" making it easier for bank borrowers to pay back loans.

"While we appreciate concerns on credit as the largest outstanding risk, we believe that losses will remain manageable," he wrote.
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Net interest margins

Banks' profit margins fell last year as the Fed's rapid rate hikes prompted their depositors to seek higher interest payments on their cash. 

That pressure should ease off a bit, thanks to the Fed's pivot toward eyeing rate cuts, but analysts caution that deposit competition isn't over.

"The risk is still there," Theresa Paiz Fredel, senior director at Fitch Ratings, said in a recent interview. 

Corporate and commercial depositors were the first to seek higher interest rates on their spare cash, leading to a sharp rise in banks' interest expenses. Consumers, too, have been able to get rates above 4.5% on certificates of deposit — which locks up much-needed cash for banks but comes at a cost. 

Rising deposit costs have crimped banks' net interest margins, a measure of the difference between the interest income banks earn and their interest expenses.

NIMs have also been held down at some by banks' pandemic-era bond purchases, since the bonds many purchased paid little interest. On the loan side, analysts foresee a relatively weak year for loan growth, thanks to higher rates lessening demand, bank underwriting getting tighter and some banks' efforts to scale back their business

All that points to another drag-down in the interest income banks will get this year.

"Margins likely still have a couple more quarters of pressure remaining," RBC's Cassidy wrote, though he added margins should start to expand later this year as banks swap out their low-paying bonds for higher-paying ones in today's higher-rate environment.
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Expense cutting

With their profitability easing, banks are sure to continue the cost-cutting campaigns they implemented in 2023. 

Wells Fargo, USAA and BMO Financial Group all announced job cuts in 2023, as did TD Bank, PNC Financial Services Group, Citigroup and Zions Bancorp.

"I talk to our peers, and everybody's looking for ways to cut costs," Zions CEO Harris Simmons said at a conference in September.

The expense-cutting may be particularly prominent among banks with $100 billion of assets, according to bank analyst Meredith Whitney. Many in that group are actively shrinking their balance sheets as they prepare to face tougher capital requirements from the Federal Reserve.

Smaller banks should be the "beneficiaries of the consequences of the larger banks de-risking/shrinking their balance sheets," Whitney wrote in a note to clients, adding that she hopes that smaller banks can face an "easier path to consolidation" if regulators take a welcoming tone on bank mergers.

One counterweight will be technology spending, which analysts expect will ramp up further in 2024 as part of banks' efforts to modernize their operations and reduce staff. Also putting pressure on banks is the labor market, where competition for workers has prompted wage increases and raised banks' expenses.

Though the announcements have slowed, several major banks and regional lenders announced in 2022 they were raising their minimum wages. Analysts expect the competition for employees will persist.

"Pressure on compensation given wage inflation and a tight labor market are likely to continue into 2024," analysts at Raymond James wrote last month. "We expect banks will respond to such pressures with a mix of ongoing tech investment and branch closures to temper the rise in costs."
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Fee income

The other lever banks can pull for revenues is fee income, but how large that stream will be for each bank will depend on where they focus. 

Wall Street banks and regional banks that help arrange mergers may see a windfall if M&A activity rebounds after a lackluster 2023. High rates and economic uncertainty led to less dealmaking last year, but the optimism in markets the last few weeks could point to a shift. 

Recent commentary from large banks and boutique dealmaking firms suggests "pent-up demand and strong pipelines," according to Jefferies analyst Ken Usdin. Consensus estimates from analysts also point to a "sizable rebound" in investment banking fees of more than 20%, he wrote. 

"In the beginning of the new year, it will be important to see some announcements get out the door … for expectations to be maintained," Usdin wrote, pointing to Goldman Sachs and Morgan Stanley as major beneficiaries of renewed M&A activity.

Banks also get fee income from their mortgage lending, which may rise in 2024 thanks to lower rates and continued demand for homebuying. But Usdin noted that that segment is "now a very small part of bank revenue streams," thanks to the dominance of nonbank lenders and banks' downsizing in the sector.

Raymond James analysts wrote mortgage income expectations are low, as higher rates continue dragging down activity.

Banks may get a boost from the recent gains in stock markets, which bodes well for banks' wealth and asset management revenues, Raymond James analysts wrote. 

And those that have held on to their insurance brokerage businesses may see a fee boost as insurance prices remain "very strong," Raymond James analysts wrote. But in recent months, more banks have sold those businesses as they look to bolster their capital positions and capitalize on high insurance valuations.

"On balance, we look for flattish growth in fee income in 2023," they wrote in December.
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