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When Rates Rise: As Risk Of Recession Rises, So Has U.S. Banks' Spread Income


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U.K. Banks Face The Weakening Macroeconomy From A Resilient Balance Sheet Position


U.S. Financial Institutions CRE Asset Quality Is Resilient: Long-Term Risks Remain


Nordic Banks: Robust Capital Provides Cushion Against Tougher Times

When Rates Rise: As Risk Of Recession Rises, So Has U.S. Banks' Spread Income

As the Federal Reserve tightens monetary policy, with the difficult aim of reducing inflation without triggering recession, U.S. banks are poised to benefit substantially from higher rates--particularly if the economy can avoid a hard landing. Assuming the Fed raises its target for the federal funds rate in 2022 to 3.00%-3.25%, we expect net interest income to rise 15%-20% this year. This would be the largest increase in more than 40 years, boosting preprovision earnings and supporting solid profitability.

That increase--which likely will be followed by a further increase in 2023 unless the Fed were to reverse course--could also provide substantial support to bank profitability and help banks absorb a potential recession. The U.S. economy contracted in the first two quarters of 2022, and S&P Global economists see a 40%-50% risk that the economy will perform poorly enough to fall into a recession within the next 12 months (see "U.S. Business Cycle Barometer: The Party's Over," July 27, 2022). A downturn, depending on its depth and length, could result in a significant increase in provisions for credit losses.

If higher rates hold, we believe banks most likely could largely or fully offset higher provisions with increased net interest income and maintain good earnings, unless the downturn is severe. Conversely, if inflation falls substantially, allowing for rate cuts amid a downturn, the gains banks are now seeing could dissipate or reverse.

Our Base Case: Higher Net Interest Income Helps Support Good Earnings

In their base case published earlier this summer, S&P Global economists expected positive but decelerated real GDP growth of 2.0% this year and 1.6% in 2023, in what they termed a low-growth recession. (Since then, second-quarter real GDP numbers showed a contraction. If the projections of our economists for the second half of 2022 prove accurate, full-year growth would be around 1.8% rather than 2.0%).

We expect the Fed to raise its target for the federal funds rate--which was 0%-0.25% at the beginning of the year--to 3.00%-3.25% by year-end 2022 and 3.50%-3.75% by midyear 2023 with inflation falling to the Fed's target by the second quarter of 2024. We forecast unemployment will rise gradually to 4.1% by year-end 2023 and 5% in 2025 from 3.6% in May 2022.

That scenario, notwithstanding the slowdown in growth, would be very favorable for banks' performance because it would allow for substantial net interest income growth and manageable pressure on asset quality thanks to continued expansion in the economy.

The Fed's interest rate hikes have already boosted banks' net interest income. At the median, rated banks reported a 23 basis point (bps) increase in net interest margins and a 9% rise in net interest income in the second quarter compared with the first. We expect further increases, helped by the Fed's 75-bps rate hikes in June and July and likely additional hikes this year, with net interest income rising for the industry by 15%-20% in 2022 and further in 2023. Several banks, including some of the largest, have indicated they expect net interest income growth near 20% or higher for the full year.

That growth could drive an extra $80 billion to $105 billion in pretax earnings in 2022 for the banking industry, equating to roughly 3.5%-4.5% of equity on a pretax basis. That percentage increase would top every year since at least the 18% and 22% rises in 1978 and 1976, respectively. Net interest income has risen more than 15% annually only seven times since 1935, according to Federal Deposit Insurance Corp. (FDIC) data.

The currently inverted yield curve may hinder the improvement in net interest income to some degree. However, we believe banks' interest sensitivity is largely dependent on short-term rates, meaning the decline in longer-term yields should not have a large impact at least in 2022.

Higher net interest income would allow banks to absorb increasing provisions for credit losses, falling fee income, and rising expenses. We still expect bank earnings to fall this year compared to 2021--when earnings benefited from substantially negative provisions for credit losses. However, the increase in net interest income should drive preprovision net revenue higher, above even the pre-pandemic level in 2019, helping support a return on equity (ROE) of around 10%. In 2023, earnings could rise higher on additional net interest income, assuming the Fed does not cut rates amid recession.

Banks in certain other countries are also likely to get a boost from rising rates. For instance, U.K. banks reported strong earnings in the first half of 2022 on the back of sharp growth in net interest income (see "Higher Rates Spur U.K. Banks' Strong First-Half Earnings Amid A Weakening Economic Outlook," Aug. 10, 2022). Likewise, large banks in Europe have generally estimated that higher rates will significantly boost their net interest income (see "When Rates Rise: Not All European Banks Are Equal," June 8, 2022).

The Downside Case: A Recession Offsets Some Of The Benefit of Rising Net Interest Income

In June, our economists published a potential downside scenario, with a roughly one-in-three probability, in which price pressures would broaden further across the supply chain, forcing the Fed to further accelerate tightening even as growth slows. The economy would slow to 1.6% growth in 2022 and contract 0.6% next year. Unemployment would rise to 6% by the end of 2023 and reach 7.2% in late-2024 from below 4% in 2022 even as the inflationary shock dissipates (see "Credit Conditions North America Q3 2022: Credit Headwinds Turn Stormy," June 28, 2022).

While the faster rate hikes would support net interest margins, banks would see offsetting negatives. Loan growth likely would decelerate or turn negative, limiting some of the benefits of higher rates. More importantly, asset quality would deteriorate on rising unemployment, higher rates, and other factors, triggering significant increases in provisions.

Still, we believe rated banks could largely manage through such a scenario. For one, net interest income probably would still grow in 2023, likely at least in the low- to mid-single digits, on Fed tightening. It would take a meaningful deterioration in asset quality before a rise in provisions would far exceed a potential rise in net interest income. We believe banks could earn an ROE in the high-single digits in 2022 and 2023 barring a severe deterioration.

To be clear, this represents a realistic and more challenging scenario rather than a hypothetical severe stress scenario. Perhaps a more stressful scenario for banks would involve a sharper contraction in GDP next year, beyond the 0.6% contraction in our downside scenario with a concurrent drop in inflation, causing the Fed to cut rates again. That could trigger a reversal of some of the net interest income gains on top of a rise in provisions.

Chart 1


Table 1

Base Case and Downside Case: Potential Year-on-Year Changes On Income Statement, All FDIC-Insured Banks
Bil. $ 2021 actual 2022 base case: Y/Y change 2023 base case: Y/Y change 2022 downside: Y/Y change 2023 downside: Y/Y change
Net Interest Income 527 80-105 40-60 70-80 20-40
Provisions (31) 70-80 15-25 100-110 10-20
Noninterest Income 300 (10)-0 0-10 (15)-(5) (5)-5
Noninterest Expense 510 25-35 15-25 30-40 20-30
Pretax Income 352 (45)-5 (20)-40 (95)-(55) (35)-15
PPNR 318 35-75 5-55 15-45 (15)-25
Resulting ROE (%) 12 10-12 9-13 8-10 7-10
Year-over-year % change
Net Interest Income 15-20 5-10 13-15 3-7
Provisions N.M. 38-51 N.M. 14-25
Noninterest Income (3)-0 0-3 (5)-(2) (2)-2
Noninterest Expense 5-7 3-5 6-8 4-5
Pretax Income (13)-3 (7)-11 (27)-(16) (14)-5
PPNR 11-25 1-14 5-14 (5)-7
Base case and downside for 2022 shows year-on-year changes versus 2021 actual results. Base case and downside for 2023 shows year-on-year changes versus respective base case and downside for 2022. Y/Y--Year over year. N.M.--Not meaningful.

Table 2

Key Factors And Assumptions Driving Our Forecast
Variable Base case Downside case
Real GDP growth 1.5%-2.0% in 2022 and 1.6% in 2023 1.6% in 2022 and (0.6%) in 2023
Fed's target range 3.00%-3.25% by year-end 2022 and 3.50%-3.75% by midyear 2023 3.00%-3.25% by year-end 2022 and 3.50%-3.75% by midyear 2023, though the Fed may move faster to those levels
Bank interest sensitivity Asset betas exceed liability betas by a wide margin in 2022, but liability betas catch up by year-end 2023 with both around 50%. Asset betas exceed liability betas in 2022, but liability betas close much of the gap in the fourth quarter and match asset betas in 2023.
Asset quality Asset quality metrics start to move toward historical averages in the second half of 2022, and banks see normalized net charge-offs in 2023 (about 50 bps). The ratio of allowances to loans moves modestly higher in the second of 2022 and 2023 (about 1.5%-1.6%). Banks see indications of impending material asset quality deterioration and proactively boost their allowances relative to loans to 1.7%-1.8% in the second half of 2022 with charge-offs moving above 50 bps in 2023 and 2024.

Table 3

Net Interest Margin And Net Interest Income, Changes And Company Guidance
Sorted by largest NIM increase in the second quarter
Bank Net interest margin change (bps), Q/Q Net interest income change (%), Q/Q Net interest income change (%), Y/Y Company approximate guidance for full-year 2022 net interest income (%)*

Comerica Inc.

55 23 21 31%

Texas Capital Bancshares Inc.

45 12 8 N.A.


40 8 9 N.A.

S&T Bancorp Inc.

40 11 10 N.A.

First Horizon Corp.

37 13 9 N.A.

M&T Bank Corp.

36 56 50 56% (affected by acquisition)

East West Bancorp Inc.

36 14 26 30%-35% (ex-PPP loans)

OFG Bancorp

35 9 13 N.A.

Commerce Bancshares Inc.

34 11 12 N.A.

Fifth Third

33 12 11 17%-18%

Trustmark Corp.

32 13 (6) High-teens % (ex-PPP loans)

BOK Financial Corp.

32 2 (2) 7% (ex-PPP loans)

First Citizens Bancshares

31 8 102 High-teens % (adjusted for acquisition)

Northern Trust Corp.

30 20 37 NA

Citizens Financial Group Inc.

29 31 34 27%-30% or higher (affected by acquisition)

Associated Banc-Corp

29 15 20 23% or higher

Valley National Bancorp

27 32 39 35% (based on co. guidance for second half 2022; affected by acquisition)

Huntington Bancshares Inc.

27 10 50 High-teens to low 20% area for 4Q22 versus 4Q21 (ex-PPP loans and purchase accounting accretion)

Zions Bancorporation N.A.

27 9 7 N.A.

Umpqua Holdings Corp.

27 8 8 N.A.

UMB Financial Corp.

25 7 12 N.A.

First BanCorp.

23 6 6 N.A.

Cullen/Frost Bankers Inc.

23 16 12 Low 20% range

Wells Fargo

23 11 16 20%

Hancock Whitney Corp.

23 8 5 N.A.


22 9 18 20% (based on co. guidance for 3Q)

Synovus Financial Corp.

22 8 11 N.A.

Regions Financial Corp.

21 9 15 16%-18% or 19%-21% ex-PPP

Citigroup Inc.

19 10 14 10% ex-markets (based on co. guidance for second half of 2022)

First Commonwealth Financial Corp.

19 8 8 N.A.

Bank of America

17 8 22 20% (based on co. guidance for 3Q and 4Q)

F.N.B. Corp.

15 8 11 16%-20%

U.S. Bancorp

15 8 9 Mid-teens %


15 8 8 10%-12%

Cadence Bank

14 4 80 N.A.

State Street

14 15 25 24%-27%

River City

14 7 5 N.A.

Truist Financial Corp.

13 7 5 N.A.

JPMorgan Chase

13 9 19 30% ex-markets

Bank of New York Mellon

13 18 28 Low 20% range

First Republic Bank

12 9 24 N.A.

SVB Financial

11 8 60 Mid 40% range (affected by acquisition)

Ally Financial Inc.

11 5 27 N.A.

New York Community Bancorp Inc.

9 8 8 N.A.

Discover Financial Services

9 5 14 N.A.

Webster Financial Corp.

7 23 120 >100% (affected by acquisition)

Capital One Financial Corp.

5 2 13 N.A.

SLM Corp.

0 (3) 7 N.A.

Synchrony Financial

-20 0 15 N.A.

American Express Co.

NA 7 30 N.A.

Morgan Stanley

NA 3 22 N.A.

Goldman Sachs

NA (5) 6 N.A.
MEDIAN 23 9 14
N.A.--Not available. Q/Q--Quarter over quarter. Y/Y--Year over year. *Company guidance is sourced from earnings releases and public calls and is sometimes estimated based on company expectations for the second half of 2022.

Asset-Sensitivity And Abundant Deposits Are Driving Net Interest Income Higher

Banks entered this period of rising rates as asset sensitive, meaning they expected their assets to reprice faster than their liabilities, driving strong net interest income growth.

In the second quarter, rated banks reported an earning asset beta of 50% at the median--meaning their yields on earning assets rose at about half the amount that the average effective federal funds rate rose for the quarter. The beta for interest-bearing liabilities was only 12%.

Within earning assets, the betas on loans and securities approximated 31% for rated banks, at the median. The overall earning asset beta also benefited from the reserves banks held at the Fed as well as a change in the mix of assets toward loans away from cash and securities.

The beta on reserves at the Fed was 100% since the Fed raised the rate it pays on those reserves as part of its monetary policy. The Fed's balance sheet showed that banks had more than $3 trillion of deposits at the Fed.

The beta on interest-bearing deposits was also 12% at the median for rated banks. We believe banks held the rate they pay on most traditional retail accounts roughly flat. However, they likely increased the rate paid on internet-based deposits as well as some types of commercial deposits. Some banks, particularly large banks, appeared willing to allow a run-off of nonoperational commercial deposits rather than increase the rate they pay on those deposits.

We expect more run-off of such deposits and likely limited or negative overall deposit growth in the coming quarters due to the Fed's monetary tightening tools. First, the Fed is extending overnight reverse repurchase agreements, effectively borrowing cash from financial institutions on a collateralized basis. Those reverse repos, which we believe are mostly conducted with money funds, have risen by about $600 billion since the Fed began raising rates in March. If bank depositors move more of their money into money funds, those money funds will likely in turn transact with the Fed, leading to pressure on deposits and liquidity in the banking system.

Second, as it carries out quantitative tightening, the Fed will allow almost $50 billion of its securities to mature and run-off each month through August 2022 and then $95 billion a month after that. That could add up to almost $500 billion in the second half of 2022 and more than $1 trillion in 2023 if that pace holds.

While those actions will extract liquidity from the financial system and weigh on deposits, there could be some partially offsetting factors as rates rise. If the yields on low- or risk-free securities rise above the rate the Fed pays in its reverse repo program, money funds and others may buy those securities rather than transacting with the Fed. Money funds held more than $1 trillion of repos with the Fed even before it began tightening. Such funds could move back into the financial system as rates rise.

We also expect the Fed to closely monitor reserves in the system and to adjust its quantitative tightening policy if it believes those reserves could fall too far.

Still, we expect the loans to deposits ratio to rise from historically strong levels. After falling to around 55% on the back of quantitative easing from around 70% before the pandemic, that ratio is likely to climb to 60%-70% in 2023, depending on the Fed's monetary policy decisions next year.

The asset sensitivity of banks--while currently beneficial--could also pose a risk later. If the Fed ultimately reverse course and cuts rates, the banks that are the most asset sensitive could see significant drops in net interest income. For that reason, we typically look favorably on banks that manage their interest rate sensitivity to be roughly neutral.

Chart 2


Chart 3


Provisions Will Rise As The Economy Weakens, But Higher Net Interest Income Should Support Earnings

Banks' evolving expectations for the economy and lifetime losses on their exposures, net charge-offs, and loan growth will determine provisions (see tables 4-6).

In our base case, we expect rising provisions in the second half of the year to drive full-year provisions of $40 billion to $50 billion, up sharply from the negative level of 2021 but still below the $55 billion pre-pandemic level of 2019. We also expect banks to modestly increase their allowances relative to loans (equating to their expectation for lifetime losses). We estimate that ratio was 1.54% in the second quarter, near the level it was prior to the pandemic and well below the 2.3% peak during the pandemic.

In our base case for 2023, we expect provisions to eclipse the 2019 level as asset quality metrics normalize further and a deceleration of the economy strains some borrowers. However, the rise in net interest income should make that increase in provisions very manageable for the banking industry.

It would likely take a significant worsening of the economic outlook before increasing provisions threaten the industry's profitability or even lead to very low earnings, thanks in large part to improving net interest income.

For instance, if banks became more pessimistic in the second half of 2022 and thereby increase their allowances relative to loans to a hypothetical 1.80% by year-end, it could mean provisions of around $75 billion to $85 billion for the year. That would be about $35 billion more than we forecast in our base case, but banks likely would still earn a high-single-digit ROE. It would probably take provisions closer to the 2020 level of $132 billion before ROE fell into the mid-single digits.

Table 4

Key Factors And Assumptions Driving Our Forecast For Provisions For Credit Losses
Key factor 2022 assumption 2023 assumption
Economic performance and banks' estimate of lifetime losses Decelerated but positive GDP growth for the full year and a modest increase in the allowances to loans ratio. That ratio, which factors in banks' estimate of lifetime losses on their exposures, fell from a peak of about 2.3% in third-quarter 2020 to around 1.5% in second-quarter 2022. With the economic outlook weakening, we think it will rise modestly toward 1.6% in the second half. GDP decelerates further in 2023 but remains positive for the full year. Unemployment ticks up. After increasing their allowances-to-loans ratio in the second half of 2022, banks modestly increase the ratio further in 2023.
2022 net charge-offs Banks' net charge-offs relative to loans, which were around 20 bps to 25 bps in the first half of the year, inch up slightly in the second half. Still, they remain low at 30 bps or less for the full year, below the roughly 50 bps the industry charged-off in pre-pandemic years. Net charge-offs rise toward their historical average of closer to 50 bps due to a deceleration in the economy and some rise in unemployment.
Loan growth Loans rise at a high-single digit pace. The more loans banks add, the more they will have to provision to add to their allowances for lifetime credit losses. Loan growth accelerated, particularly in the second quarter. Even if its slows materially in the second half, it should still be up by at least a mid-single-digit pace for the year. Loans rise at a low- to mid-single-digit pace, slowing with the deceleration in the economy.

Table 5

2022 Provisions (Bil. $)
Sensitivity to net charge-offs and loan growth, assuming allowance to loans of 1.6%
Loan growth (%) --Net charge-offs--
0.20% 0.25% 0.30% 0.35%
5 30 35 41 47
7 33 39 45 50
9 37 43 49 54
11 41 47 52 58

Table 6

2022 Provisions (Bil. $)
Sensitivity to allowance Llevel and loan growth, assuming net charge-offs to loans of 30 bps
Loan growth (%) --Year-end 2022 allowance to loans--
1.50% 1.55% 1.60% 1.65%
5 29 35 41 47
7 33 39 45 51
9 37 43 49 55
11 40 46 52 59

Rising Expenses And Fee Income Pressures Will Limit Earnings

In the first half of 2022, rated banks mostly reported meaningful increases in expenses and modest or negative changes in noninterest income compared with the prior year. We expect those trends to carry through the full year with further pressure in 2023. We forecast 6% and 4% expense growth for the industry this year and next, respectively, as well as a 3% decline and little change in noninterest income in 2022 and 2023, respectively.

Inflation, tight labor markets, and business investments, notably in technology, have driven up expenses by about 6% at the median and in aggregate for rated banks.

Weak investment banking and mortgage banking in particular have hurt noninterest income. Banks with dependence on those activities have seen meaningful declines in noninterest income while many others have seen little change. The large banks with significant investment banking operations, for instance, have driven an overall drop in fee income for the industry.

We Continue To Consider The Performance Of The Economy And Banking Sector In Our U.S. BICRA

In May 2021, we announced a change in parts of our Banking Industry Country Risk Assessment (BICRA) for the U.S. after observing positive developments in the U.S. banking system related mostly to the country's improved regulatory track record for banks, the good financial performance of its banks prior to and during the COVID-19 pandemic, and the rebounding economy (see "Various Rating Actions Taken On Large U.S. Banks And Consumer-Focused Banks Based On Favorable Industry Trends" and "Various Rating Actions Taken On U.S. Regional Banks Based On Improving Economy And Favorable Industry Trends," May 24, 2021).

We use the BICRA to set the anchor, or starting point, for our ratings on financial institutions in each given country. These changes to the U.S. BICRA could, within one to two years, result in a higher anchor for the U.S. and therefore higher ratings on some banks. In addition, we may revise up the anchor if the current stringency of regulation remains in place, the economy continues to grow, and banks maintain strong balance sheets and good asset quality as they emerge from the pandemic.

While regulation has not eased and banks continue to perform well, other economic-related risks and challenges have emerged--most notably higher-than-expected inflation, the Russia-Ukraine conflict, and rising recession risk.

We are continuing to monitor all of these factors and assessing their potential impact on banks. As we gain more clarity into the direction of the economy and the impact on banks, we will consider the implications for the U.S. BICRA.

This report does not constitute a rating action.

Primary Credit Analyst:Brendan Browne, CFA, New York + 1 (212) 438 7399;
Secondary Contacts:Stuart Plesser, New York + 1 (212) 438 6870;
Devi Aurora, New York + 1 (212) 438 3055;

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