US Recession Could Put Banks' Profits at Risk

The market volatility and interest-rate hikes that gave US banks their biggest windfall last year may prove to be their biggest headache in 2023. While these factors may have been beneficial in the short-term, they could have negative long-term effects on the banks. As a result, 2023 could be a difficult year for US banks.

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When the nation's biggest banks report their fourth-quarter earnings on Friday, investors will be more interested in seeing how well prepared they are for a major downturn than in how profitable they were in the final three months of last year. This is because higher interest rates are expected to slow down economic activity in the near future.

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Jason Goldberg, an analyst at Barclays Plc, said in an interview that we are entering a period of uncertainty from a period of strength. He noted that despite the fact that we may be facing a recession, loan losses are at record lows, trading remains elevated, and net interest income will set records at the banks. However, he said that everyone is scared of their shadow.

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The quarterly results could be bolstered by strong fixed-income trading and record net interest income, offset by increased provisions for bad debt, a decline in underwriting, and fewer mergers and acquisitions. If the economy weakens and geopolitical tensions persist, these headwinds could intensify.

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To get an idea of how the banking sector is faring, keep an eye on results from banks that are set to report later this week. Key things to look out for include loan growth, net interest margins and provisioning for bad loans.

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Interest rates have remained high, which has increased net interest income for banks. This is the difference between what banks make on loans and what they pay depositors. Analysts predict that the four biggest banks will have pulled in about $59 billion from this source in the fourth quarter. This is compared to $45 billion in the same period a year earlier. However, it is possible that this trend will not continue.

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Goldberg said that the fourth quarter will be a record for NII, but that they predict it will plateau as the year goes on.

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Interest rates are on the rise, driving up NII (net interest income) for banks. However, a recession may be looming on the horizon, which could put a damper on things.
As long as the Federal Reserve continues to raise interest rates and keep them at a high level, NII will probably continue to benefit. However, the positive momentum is likely to start fading in the next few quarters.

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The potential for a recession could overshadow the recent peak in NII, hampering profit growth. Slower loan growth as consumers and corporations start to pull back on borrowing, along with elevated expenses, will also be factors to watch, according to Evercore analysts led by Glenn Schorr.

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All of the major US banks posted gains in net interest income in the third quarter, with some raising their NII forecasts for the rest of the year. Lenders have been eager to charge higher rates to borrowers, but slower to pass on benefits to savers who have deposited trillions of dollars with the country's biggest banks. The mix of deposits will be in focus after signs of outflows in recent quarters.

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If customers start withdrawing some of their deposits, it could put pressure on banks to start paying higher interest rates. This could have a negative impact on future gains from net interest income.

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Volatility has continued to fuel the trading bonanza, pushing revenue from that business to the highest levels in more than a decade. Wall Street’s five biggest trading desks are set to notch $22 billion in revenue for the quarter, a gain of 9.5%. Most of that will come from fixed-income desks, where commodities, currencies and rates traders had one of their busiest years ever.

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Volatility continued to be a major driver of revenue growth in the fourth quarter. This was especially evident in the company's strong performance in the stock market.
Fixed-income traders are expected to see gains of around 22% this year, while equity traders are projected to see a 4.5% decline compared to last year. The above-average volatility and increased trading volumes are seasonally atypical, but Credit Suisse Group AG analyst Susan Roth Katzke said in a note that they are generally in line with levels seen a year ago.

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This is a tough environment for dealmaking and capital markets, which have suffered amid the market turmoil of the past year. Investment-banking revenue at the six largest banks is projected to plunge 51% in the fourth quarter compared to the prior year.

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Wells Fargo & Co. analysts led by Mike Mayo predict that a pause in interest rate hikes and a stabilization in asset prices during the first half of 2023 will open the door for increased dealmaking activity during the second half of the year. This is good news for bankers who have been feeling the squeeze lately.

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Executives are set to reveal how much they are preparing for a recession, and how likely that outcome is. The potential for bad loans has forced lenders to set aside more money in reserves, which is the opposite of what they did in the wake of the pandemic.

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Analysts are expecting a total of $5.4 billion in loan-loss provisions for the four biggest banks. This is a significant increase from the $3.6 billion in provisions that these banks set aside in the previous quarter.

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Banks have already hinted at cautious outlooks for 2023, with some announcing cost-cutting measures to keep expenses down. Goldman Sachs Group Inc., which reports results Tuesday, is working on a fresh round of job cuts to offset slower economic activity and curb expenses. Morgan Stanley, Credit Suisse and Barclays Plc have all either already fired staff or announced that they plan to do so in coming months. This is in response to the slower economic activity that is projected for the next year.

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Despite concerns about a slowing economy and possible recession, analysts believe that banks will be able to overcome any challenges and expand their earnings in the new year. Compared to the global financial crisis, the current concerns about the banking industry are much less severe, as banks have taken measures to strengthen their balance sheets and prepare for another downturn.

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While some financial institutions have looked to offer custody services for digital assets, a rule imposed by the Securities and Exchange Commission last year that requires publicly traded companies to treat crypto held for clients as a liability makes holding the tokens prohibitively capital-intensive.

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"BNY's plan to offer crypto custody is a positive step for the industry," said Owen Lau, an analyst at Oppenheimer. "It will inject more confidence into the crypto industry and drive crypto adoption." Lau added that the industry does not want to see a big player like BNY pulling back from crypto investment, as it could have a domino effect on other big players.

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Investors will be closely watching the smaller banks that have gotten more involved in the cryptocurrency industry, such as Silvergate Capital Corp. and Signature Bank. Any change in attitude toward the industry by big bank CEOs like Jamie Dimon will be closely watched as well.

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