Bank earnings continue to beat expectations in the current quarter with managements overwhelmingly maintaining very defensive forward postures. The US Treasury curve flattened substantially through a bear steepening path with 2/10 spreads the least inverted since July 2022. Risks outside the economy and financial system continue to escalate.
After a full week of 3Q23 earnings releases with 48 banks with greater than $10B in assets reported, 75% have beaten consensus EPS expectations. Expense control has been a key driver to better results as loan growth is only higher by a median 0.4%. Credit quality remains very good with normalization trends in consumer segments like credit cards. Commercial stresses are becoming evident where loan resets to higher interest rates are resulting in adverse valuation and cash flow changes. Provision expenses are down modestly from June while relative reserve (LLR/R +7 bps to 1.26% q/q) and capital (CET1 +27 bps to 10.75% q/q) levels are increased.
Funding pressures from the first half of the year have mostly stabilized. Median Net Interest Margin (NIM) is running at 3.19% down from 3.27% in June or approximately -1.5%. Net Interest Income (NII) is lower a median -1.1% sequentially. NIM and NII dispersion is such that 29% of banks in the group reported higher spreads. Most of those for whom spreads were still compressing projected inflection in the next 2 quarters assuming the current forward rate curve.
Deposit mix has now experienced most of the non-interest bearing to interest bearing or money market shifts. Changes to account balances from ongoing cash flow pressures will likely be the larger funding issue over the next few quarters. Commentary from BAC CEO Brian Moynihan helped frame the deposit remix which has mostly completed (my emphasis).
“So where people think about checking and money markets in this, we think which is transactional cash and investment cash? The investment cash has largely been resuited across the businesses. The transactional cash holds because it’s money in motion moving every day. And for our Consumer business, that’s represented by the $0.5 trillion of checking account balance with some modest amounts in money markets and stuff that are carried as the cushion people have. And if they move the money in the market, they’ve moved it.
And so we’re watching Consumer because there’s a little more drifting there, and it’s up $250 billion since pre-pandemic. And you’re saying you have the dynamics of loans, student loan repayments starting, that’s 1 million of our customers pay student loans. You have the dynamics of interest rate impacts on cash carry of loan balances, so that’s higher. And that will sort out, but it takes a lot longer. That’s across 37 million people, so it’s — the impact we’ll have to sort through.
I believe the hand wringing regarding NIM & NII compression is more in the past than a forward risk. For me, forward risk is more centered on credit both from lagging impacts from higher interest rates still moving through the system and potential economic contraction. FITB CEO Tim Spence offered germane commentary in this regard (my emphasis).
“You have a lot of variables underway here. You have the Fed and rates, as you mentioned, you have an immense amount of government spending right now, which is propping up economic growth in certain sectors of the economy that otherwise wouldn’t be there. You have sort of unusual times in the housing market, where we have both high rates and still stable or even in some markets, slightly growing home prices, even the home affordability is at an all-time low.
I think, more than anything else, we need to see some of those variables get fixed. So if the Fed stops raising rates and then introduces a cut, I think that would be helpful. I think that we have to see the last of the stimulus dollars come out of consumer accounts and see what the floor looks like in terms of consumer spending. And then I think we have to have a better sense for what the underlying economic activity looks like in areas where the government spending the $2 trillion that are coming out of the various government programs are not driving a lot of the economic activity for people to get a little bit more focused. Because again, what I hear and I went out to have the opportunity to get feedback from about 3 dozen clients shortly before the call here, is they’re seeing a gradual slowdown that is essentially disposable income.
They’re seeing disparities on the consumer side between either the businesses or take hotels, hotel properties that either cater to retired people or to high-end consumers in high-end destinations continue to do well, whereas the mass market properties are starting to soften. We hear them on the B2B side being much more guarded as it relates to liquidity and monitoring cash and adjusting staffing levels and just delaying the larger CapEx investments here.
And I think an interesting data point, as I had the chance to spend a little bit of time with the head of economic development for one of the large states in our footprint and I was asking about the new project pipeline. So yes, pipeline is still robust. There’s a lot of discussion going on, but the time to decision from when they’re initially contacted about a potential opportunity for either a new plant or a headquarter relocation or otherwise to the award in a given state has moved from 200 days as recently as 18 months ago to over 500 days. So you can just see the grind down here of economic activity as people sit on the sidelines and wait to get a better sense for what direction we’re headed on the economy.”
What I take away from Spence’s comments and dozens of other bank executives is that there is greater than normal uncertainty in both their board rooms as well as their clients. Broadly banks and their retail and commercial clients plan to remain defensively postured until that uncertainty is resolved. This relates to inflation, restrictive monetary policy, fiscal stimulus and geopolitical risks. To me, caution is exactly the right posture for bank executives. If banks prioritize long term customers, build capital, reduce duration risk and triage clients impacted by the sharp change in interest rates, they should emerge with long term franchise value fully intact.
Spence was good for a couple of other points with which I agree. If I am correct and funding issues are mostly past us, then credit risk becomes a greater priority for the outlook. Timing on credit risk realization seems to be continually pushed out.
“I think we have fairly good visibility into what the first half of the year is going to look like. And we’re not seeing anything at the moment that would suggest that we’re headed toward credit deterioration in the first half, right? We talked about it in the script delinquency formation that delinquency rates are actually down on the early-stage basis. NPAs are down sequentially, and we have a roll forward for you in the appendix. The slides, which would indicate that, that trend is likely to continue through the fourth quarter. And on the Consumer side, just as an example, the nice thing about the way that we manage delinquencies is it’s like an assembly line. So you can see in the 0 to 29 and then the 30-plus buckets what you’re going to be dealing with or early next year, and there just isn’t anything in there to be worried about.”
When I think about key drivers to industry earnings models, NII/NIM has troughed or will trough while credit cost will likely remain benign another quarter or 2 minimum. The set up is for further EPS beats and capital build. Another positive when thinking about banks is the healing quality of time. My thoughts are specific to the widely discussed unrealized asset marks that have already flowed through income statements. Every quarter that passes shortens duration to legacy asset portfolios and reverses prior marks in a flat rate environment. As Spence calls out, what has been a headwind can through time reverse to a tail wind if overall liquidity is managed.
“If you believe that the AOCI mark is weighing on the stock, then the other way to look at it is the burn down is 25% accretion in tangible book value per share in the next 2 years just given the current outlook on rates, which is a pretty unique buying opportunity.”
Throughout my career, when I find the great majority of the market speaking in unison, that is typically when the best return opportunities exist.