US Banks: In brief before 1Q 2023 earning releases

The US banks’ earnings season for 1Q 2023 that kicks off on 14 April will be crucial amid the ongoing effort of policymakers and bankers to restore confidence in the US banking system after the collapse of Silicon Valley Bank and Signature Bank. For 1Q 2023, profitability of both Globally Systemically Important Banks (G-SIBs) and regional banks are likely to moderate as higher impairment provisions shall partly offset net interest income growth. Regional banks are going to face more heat due to higher exposure to stressed sector like commercial real estate. In fact, according to Federal Deposit Insurance Corporation, small and mid-size banks (asset size less than USD 250bn) account for ~80% of total commercial real estate loans. Along with rising interest rates, property investors are facing lower valuations on commercial projects due to rise in hybrid and remote working trends.

Besides, higher loan loss reserves are driven by consumer loans (particularly credit card and auto loans). This is on account of weaker economic outlook that reflects higher unemployment and lower real wage. Although not a credit crunch, but credit tightening by banks is expected in the coming quarters due to fear of asset quality deterioration in the near to medium term amid economic uncertainty.

The Fed’s policy rate hikes beginning from March 2022 have aided the banks’ interest income growth, but deposit outflows to higher yielding short-term treasuries and money market funds have surged as banks are usually slow to adjust their deposit rates to rate hikes. As a result, banks’ reliance on wholesale funding has increased thereby escalating funding costs and exposing them to rollover risk. Overall, higher impairment provisions, muted lending along with deposit competition/deposit flight to higher yielding instruments are likely to constrain banks’ bottom-line.

Furthermore, the aggregate loan-to-deposit for the banking industry has risen on the back of depleting deposits and steady credit growth. That said, this does not seem to turn in to a systemic level liquidity crisis. Moreover, the Fed’s recent intervention by introducing the Bank Term Funding program will reduce liquidity pressure as well as dependence on wholesale funding in the near term. The program is a temporary emergency lending program (set to wind down by March 2024 unless renewed) wherein the Fed lends to banks against their safest bonds like Treasuries and mortgage-backed securities’ par value instead of market value. That said, the cost of funds in this program are not cheap. So, this facility might exert pressure on banks’ profit margins depending on the volume of borrowing they do from this window. In all, its crucial for the banks to retain its stable and cheapest form of funding—core deposits. This can happen if the Fed reverses its hawkish stance and cuts rates or banks adjust their deposit rates in line with the increasing interest rates.

Besides, it is imperative for regulatory intervention in revisiting the calculation of an extremely important liquidity measure—Liquidity Coverage Ratio (LCR) and replacing the modified LCR with the standard LCR in banks (with asset size between USD 50bn to USD 250bn). The US Treasury bonds are failing to meet the standards of high-quality liquid assets of LCR as treasuries have been extremely volatile amid the rising interest rate regime, thereby leading to overestimation of LCR of banks. In fact, Silicon Valley Bank collapsed when it incurred mark to market losses on liquidation of its portfolio of Treasuries to raise cash to meet depositor withdrawals. Basically, there was a sizeable gap between the book value and market value of its bonds. It may be noted that Silicon Valley Bank was also an outlier in terms of holding a very high level of uninsured deposits.

In terms of capitalization, G-SIBs remain well-capitalized partly due to stricter regulatory guidelines. However, after the collapse of the afore-mentioned banks, tougher capital rules are expected to be introduced to small and mid-sized banks. The regulators should look in to the accounting rules in held-to-maturity and available-for-sale (AFS) securities. Any losses in AFS segment are marked to market and gets deducted from the bank’s capital base while HTM securities are excluded from this process. So, to avoid depletion of capital base, banks prefer to hold securities in HTM instead of AFS—G-SIBs had placed 70% of their bond portfolios in HTM category as at end-2022. However, the problem arises if the interest rate jumps relative to the period when the HTM bonds were issued by the bank, then the bonds have be to sold at loss if the bank needs to raise capital to repay depositors as was the case with Silicon Valley Bank. The losses didn’t get reflected in the bank’s “sound” capital ratios because of the accounting system. In addition, many are arguing that if in 2018 there was no rollback of the Dodd Frank Act—which led to exemption of banks with asset size up to USD 250bn from the Fed’s stringent supervisory measures for capital and liquidity requirements along with periodic stress tests—both the banks wouldn’t have collapsed.

NOTE: The post is for informational purposes and should not be construed as investment advice or financial research. dōnō consulting is not regulated by any financial authorities in any part of the world, is not an investment advisor nor an investment firm, and members of the firm may have long or short positions in any of the securities mentioned in the post.