Could Banks’ Credit Loss Management Lead to Strong Performance?

By Gerard S. Cassidy
Published March 6, 2023 | 4 min read

While credit conditions will likely normalize, the banking industry looks well-positioned to handle higher credit losses, and as a result could emerge stronger than ever.

Key Points:

  • While credit conditions are strong, they will invariably weaken in 2023 as a result of the expected economic slowdown. High-risk loans will be worst hit, suffering from credit deterioration due - in part - to the rise in short-term interest rates.
  • Despite this, regulatory reform has gone someway in de-risking the banking sector, which should comfortably manage credit losses over the next 12-18 months.
  • Overall, consumer credit looks healthy, particularly compared to the 2008/09 Global Financial Crisis, but Buy Now Pay Later products and sub-prime auto loans may become cause for concern.
  • The banking sector is well placed for a surge in investor interest due to its resilience.

Assessing the severity of the imminent economic slowdown is key to understanding the potential credit triumphs and pitfalls facing the US banking industry. And, despite a series of extremely disruptive events - including a global pandemic, international energy crisis, soaring inflation, and war in Europe - the American economy could be set for a milder recession than previously expected. Economic indicators are pointing in different directions and the situation is a challenge to interpret, but factors such as solid employment rates, improving inflation levels and consumer spending point towardmore mitigated disruption than predicted.

Consequently, while credit conditions will invariably weaken throughout 2023, the banking sector looks equipped to manage losses comfortably - and investors may be interested in the industry’s potential to exceed expectations.


High-risk loans will become even riskier

High-risk credit quality is the area likely to deteriorate most significantly over the next 12-18 months, as rising short-term interest rates and a changing macro environment impact expected losses. Investors may keep an eye on the performance of leveraged loans, which could carry the greatest risk. Other risk areas include low FICO consumer loans and commercial real estate mortgages - the latter as a result of changing work and shopping behaviors.

Finally, loans to non-depository financial institutions, particularly private equity and venture capital investing are also expected to deteriorate; a lack of data on high-risk leveraged lending means surprises could arise in this space over the next 12-18 months.

“We believe leveraged loans carry the greatest credit quality risk for the financial system, and have grown to record levels.”

- Gerrard Cassidy, RBC Analyst.

“But, we also believe that the majority of higher FICO score consumers, and Commercial & Industrial sectors will remain relatively healthy throughout 2023.”

This inevitable weakening of high-risk credit will cause high-risk loan portfolios to suffer. However, overall credit quality for the banking sector is strong and it is expected the industry will successfully manage this deterioration.

One significant outcome may be a sector-wide increase in loan loss provisions and loan loss reserves. Large banks are likely to build up their loan loss reserves towards the start of 2023 in anticipation of higher loan credit losses. And as a result, banks may be able to report less volatile results throughout the period.


But banking reforms have improved resilience

The banking industry today has been notably de-risked due to the widespread regulatory reform passed after the 2008-09 cycle. The Dodd Frank Wall Street Reform and the Consumer Protection Act of 2010 have worked to simplify and strengthen the sector overall. Crucially, when considering the potential credit landmines ahead, these changes have gone some way in tackling poor underwriting standards.

The result? Despite rapid loan growth in the second-half of 2022, a trend which can often lead to credit disaster, large banks have mostly maintained underwriting standards and protected credit quality.

“A key characteristic in some of the credit debacles of the past was rapid loan growth with poor underwriting standards going into the recession. We have not seen this behavior in this cycle for the large banks.”

Consumer credit is in good shape

Another encouraging sign for investors, and the banking industry overall, is the healthy state of consumer lending. Current debt levels seem manageable and are expected to remain so, in part due to the positive outlook for employment. We believe the unemployment rate is likely to remain low, which is strongly correlated to healthy consumer credit ratings. Additionally, as a result of the aforementioned regulatory reforms, residential mortgages are also in good shape.

“Though consumer lending - specifically sub-prime residential mortgage - was the catalyst for the credit debacle in 2008-09, we do not expect consumer credit problems to be as worrisome over the next 12-18 months.”

“Yes, Buy Now Pay Later products and sub-prime auto loans will likely experience elevated levels of credit losses, overall prime consumer credit losses should be manageable in a mild recession.”


Could bank stocks over perform in 2023?

For investors in the banking industry, the general outlook is looking positive - and this is for the most part as a result of the predicted management of credit losses. The Texas Ratio, an industry standard for measuring credit quality, indicates the potential for bank failures remains low - particularly among the top 50 US banks.

“We want to emphasize that credit risks still exist in the banking industry and investors should expect higher credit costs over the next 12-18 months,” states Cassidy. “But, we believe they will be manageable.”

The consequences of this could prove rewarding for bank stock performance and investors. If the industry can handle a meaningful deterioration of credit quality, then dividend payouts are expected to remain strong and there is the potential for outperformance more generally. This however, is dependent on the economy’s overall growth.

“Manageable credit losses, which we expect, will likely lead to bank stock outperformance in 2023. And, large banks should not be required to reduce or eliminate dividends or raise capital at distressed prices.”

“But, under a more severe credit downturn, akin to 1990 or 2008-09, bank stocks will likely underperform and investors should consider ownership of any bank stocks.”

Overall, the banking sector has proven resilient in the face of recent disruption – and become a vital economic pillar during the COVID-19 pandemic. The reformed and de-risked industry is now able to better manage credit losses, and this could make all the difference going forward throughout 2023. With economic and geopolitical uncertainties arriving relentlessly, a safer and more stable relationship with credit quality could limit the impact of said events.

Gerard S. Cassidy

Gerard S. Cassidy
Analyst and Head of US Bank Strategy

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