US banks to set aside $4bn for potential losses from bad loans

The biggest US banks are set to voice their concerns about the US economy in third-quarter earnings reports starting next week, with analysts expecting them to set aside more than $4 billion to cover potential bad loan losses.

Expected provisions will be far less than those that hit lenders early in the pandemic in 2020, when they increased reserves by tens of billions of dollars to prepare for an economic shock that, thanks to unprecedented monetary and fiscal stimulus, has largely been resolved was avoided.

Now, as credit demand continues to grow, banks are bracing for the possibility that rising interest rates will slow the economy and lead to higher loan losses — a concern that has weighed on bank share prices already this year.

“The macroeconomic outlook has deteriorated somewhat, so it would be only natural to expect some increase in bank reserving,” said Ken Usdin, banking analyst at Jefferies.

“As of this writing, there is not a very high expectation that losses will be instantaneous. But the bigger question is what the economy looks like over the next year to 18 months.”

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The top six U.S. banks by assets — JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs, Wells Fargo and Morgan Stanley — will collectively provide about $4.5 billion in loan loss provisions in the third quarter, analysts estimate, according to Bloomberg . It would be the third straight quarter that banks have made provisions for loan losses.

Investors will also be looking at whether banks are marking losses on leveraged buyout loans they have committed to finance but have not yet been able to sell to third parties. In the second quarter, banks suffered hundreds of millions of dollars in mark-to-market losses.

Line chart of loan loss provisions in billions of USD showing that US banks have started to hoard loan loss provisions

JPMorgan, Morgan Stanley, Citi and Wells Fargo are set to post earnings on October 14th, followed by BofA on October 17th and Goldman the next day.

The KBW banking index is down around 22 percent in 2022, compared to a roughly 20 percent decline in the benchmark S&P 500 index. The drop reflects concerns that more loans are turning sour, even as rising interest rates help lenders boost net interest income — the difference between what banks pay for deposits and what they make on loans and other assets.

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“Investors in bank stocks, a group that never tends to ‘enjoy the moment,’ are already reviewing good news and are “concerned that we are nearing peak gains,” analysts at Autonomous Research wrote.

Bank executives said US credit quality remains excellent, with defaults well below historical norms and businesses and customers still sitting on cash accumulated during the pandemic.

At an industry conference last month, JPMorgan President Daniel Pinto said, “The consumer here in the United States is in a very, very good place.”

Analysts also say major US banks are well-positioned to weather an economic downturn following stress tests organized by the Federal Reserve and new capital requirements.

“Banks enter this period of uncertainty in a position of strength,” said Jason Goldberg, banking analyst at Barclays.

Under a method introduced in 2020 called Current Expected Credit Losses, or Cecl, banks are required to build reserves in good times so that they have adequate capital buffers in the event of losses.

“The difference between the economic outlook at the end of June and the end of September has narrowed significantly. And that’s why, according to Cecl, reserve formation needs to increase,” said Gerard Cassidy of RBC Capital Markets.

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Analysts expect earnings per share for the top six banks to fall about 22 percent on average for the quarter.

Third-quarter earnings at JPMorgan, BofA, Citi and Wells are expected to grow about 4 percent year over year, benefiting from higher net interest income.

Goldman and Morgan Stanley, which derive a larger proportion of their earnings from investment banking, are likely to see revenue decline on slower dealmaking activity.

“Traditional investment banking is very weak. Stock markets are down quite a bit,” said Christian Bolu, an analyst at Autonomous Research.

The declines will sharpen focus on banks’ spending and workforce management.

Bank equity and bond trading desks are expected to continue their strong performance in the third quarter given volatile markets.

“Trade in general should be up slightly from last year’s third quarter, which was a particularly strong quarter,” Barclays’ Goldberg said.

Additional reporting by Imani Moise

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