Four of the United States’ largest globally systemically important banks (GSIBs) are reporting earnings this Friday, October 14th: Citigroup
When analyzing bank earnings, it is important to remember that banks make money in three ways: net interest margin, trading, and fees from services such as investment banking and asset management. The most volatile of these three categories are trading revenues, because they are largely influenced by country risk, macroeconomics, fiscal policies, geopolitical risk, and natural disasters which can greatly impact interest rates, foreign exchange rates, commodity prices, and securities prices.
Currently, the rising interest rate environment could help some banks increase their net interest margin, since they are now charging more for any new loans and credit products they are approving. Banks’ median net interest margin rose in the second quarter of 2022 in comparison to the same period in 2021. Banks are likely to benefit from a significant rise in consumer borrowing, which as I wrote recently, is at record highs.
However, the fear is that rising rates will make it harder for borrowers to pay back their outstanding credit, especially if those credit products, such as credit cards, are variable rate products. When bank earnings come out in the next two weeks, we should look to see what percent of loans are starting to deteriorate, otherwise known as non-performing loans (NPLs). These are loans, whose borrowers are ninety days or more in paying. If the level of NPLs is rising, we should also look to see if banks are increasing their loan loss reserves, also known, as provisions; a rise in loan loss provisions means that a bank is preparing in case borrowers were to default. The loan loss reserve is a non-cash deduction in the income statement. Hence, if banks are being prudent, we are likely to see an increase in loan loss reserves to prepare for the proverbial ‘rainy day,’ which will potentially cause a decline in net earnings, especially in banks that depend more on net interest margin rather than trading and fees. As of the end of the second quarter 2022, charge-offs have been stable. Banks normally charge off loans after borrowers are over 180 days in late payments.
Where banks could really take a hit is in their trading and fees areas, especially investment banking and asset management. Asset price volatility, due largely to uncertainty about whether the Federal Reserve can control inflation and when the Russian invasion of Ukraine will end, is likely to push trading revenues and asset management fees down, at banks. A decrease in mergers and acquisitions will also weigh on investment banking fees. Banks like Morgan Stanley and Goldman Sachs, whose revenues overwhelmingly rely on trading revenues and investment banking and asset management fees are likely take a hit; they are not as diversified as JPMorgan Chase and Citigroup, that have sizeable loan books, as well as trading and fee generating businesses.
R.C. Whalen, Chairman of Whalen Global Advisors, expects “to see reasonably strong earnings for smaller banks as loan yields slowly rise, but the transaction side of the house is likely to be weak, hurting Morgan Stanley, Citigroup, Goldman Sachs, and JPMorgan Chase.” Whalen also explained that “one name to watch in Q3 2022 will be Wells Fargo & Co (WFC), which is in the process of dramatically shrinking its balance sheet. Improved earnings in Q3 2022 may be a catalyst for this long-underperforming name. As we noted in our Q2 2022 pre-earnings setup, a modest improvement in operating efficiency at WFC, which has been in the 80% range, could be quite meaningful for the stock.”
While in the next two weeks potentially negative news about bank earnings may cause significant anxiety amongst market participants, it is important to remember where we are in the economic cycle and to remember to breathe. Yes, U.S. GDP has declined slightly for two consecutive quarters; yet, labor markets remain tight, albeit not as tight as earlier in the year. While default rates of leveraged companies, to which many banks are exposed, are rising, default rates are still significantly below where they were in 2020, not to mention during the financial crisis.
Importantly, due to Basel III and Dodd-Frank rules and strengthened bank supervisory exercises, U.S. GSIBs are well capitalized and are presently forecast to be liquid, for at least a month, even if there were a significant credit or market stress. The four banks reporting this coming Friday are all over double the required high-quality capital required to sustain unexpected losses; the Basel III Common Equity Tier I (CET
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