Investors on edge over capital hits, deposit flows in Q3 bank reports

Higher interest rates are set to deliver another surge in bank revenues in third-quarter reports, but investors are focused on the dangers of the Federal Reserve's campaign to rapidly tighten financial conditions, analysts say.

Higher rates are also translating into substantial additional hits to the market value of banks' bond portfolios, thinning capital levels at a time when a recession — if it comes — would almost inevitably raise credit losses. They are also driving outflows of deposits that are likely to create meaningful differentiation among banks' ability to control deposit costs.

"There are some banks that have low [tangible common equity, or TCE] ratios that are going to take another hit this quarter," Raymond James analyst Michael Rose said, referring to the inverse relationship between interest rates and bond values. Marks on securities holdings affect regulatory capital only at the very biggest banks, and the marks reverse when banks hold bonds to maturity.

Nevertheless, the impact could drive some large bank TCE ratios to below 5%, Rose said, limiting buyback capacity. "I would be concerned if credit becomes a bigger issue," Rose said.

The jump in interest rates across the middle of the yield curve, which encompasses the maturities of much of banks' bold portfolios, was much higher than in the second quarter and about as sharp as in the first quarter.

For now, analysts expect actual credit performance to remain strong, though robust loan growth is likely to help drive increased expenses for loss set-asides. Overall, consensus estimates project sequential increases in EPS at 15 of the 17 publicly traded banks with more than $100 billion in assets, and year-over-year increases at seven of them, according to S&P Global Market Intelligence data.

NII gusher

Analyst expectations for net interest margins and revenues are quite strong, with the consensus projecting a median sequential NIM increase of 17 basis points for the large banks, and sequential and year-over-year increases in revenue at almost all of them.

But markets appear to be looking past that good news, based on bank stock prices.

"Investor sentiment toward the group is lukewarm just as banks are about to report what is likely to be a best-in-a-decade quarter for [NIM] expansion," BofA Global Research analysts said in a note Oct. 12.

Analysts widely expect deposit price increases to meaningfully accelerate after a slow start and for competition to cut into rising asset yields. Raymond James and Keefe Bruyette & Woods expect NIM expansion to peter out after the first half of next year, while Jefferies forecasts peaks in the fourth quarter of this year or the first quarter of next year.

The BofA analysts said that consensus forecasts for 2023 EPS at regional banks have increased 12.5% so far in the year while they have fallen for most large caps across industries. However, "from here on, we expect the damage caused by runaway inflation (and reactionary monetary policy) to weigh on the fundamental growth outlook," they said. "This means slowing loan growth, rising credit costs and an eventual peak in net interest margins."

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Credit not getting cheaper

Consensus forecasts do anticipate sequential increases in net-charge off rates at almost all the large banks in the third quarter, though to a still benign median of 20 basis points.

Analyst estimates also forecast sequential increases in loan loss provision expenses at 10 of the banks. In addition to loan growth, banks might seek to add to reserves by placing higher weightings on downside economic scenarios or other discretionary moves under accounting rules, as JPMorgan Chase & Co. and Citigroup Inc. have done in recent periods.

Banks have generally argued that they are well prepared for a downturn and do not expect a rapid unraveling of credit performance. Even with a hard landing, the rise in unemployment, a key driver of credit losses, might be far smaller than in the last two recessions.

Still, credit is "the biggest wild card," Rose said.

"What we're seeing and hearing is everything looks good now," he said. But "you could paint a scenario where consensus estimates are way too high, at a magnitude of 10% to 20% at the median for next year. We don't know exactly how bad it's going to be."