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BirdsEye View

 Roberto Albertson continues to share his insights about our economy and industry after most of 2Q23 earnings calls are behind us. His unedited words are below, without any editorial comments from me. His strategy deck is also attached, and, as always, is thought-provoking and insightful.

“Sharply higher funding costs finally drove linked quarter net income comparisons negative in the second quarter, causing many banks to miss their estimates.  As a result, most banks reduced their outlook guidance for the second half.  Generally silence on 2024.

The impact from early-March bank failures and ongoing quantitative tightening was very evident.  Average deposits fell for most, although end-of-period balances were generally higher than prior quarter results.  June was particularly strong.  Managements were still cautious, indicating those balances could decline further into the third quarter.  Deposit betas accelerated with projected terminal betas reaching or exceeding 50% in many cases.  Those still holding to a 40% level are dwindling. 

Adverse mix changes worsened, with much higher migration out of noninterest bearing into interest bearing deposit and higher deposit rates driving the cost of deposit funding notably higher.  Those with active swap hedging programs did somewhat better.  Reliance on borrowings was mixed, with most attempting to reduce their FHLB advances.  Reliance on brokered and reciprocal deposits was  still rising.  Online deposit building was also highlighted for those that have the platform.  Competitive deposit pricing has entered a new level of aggressive defense.

Net interest income (NII) and net interest margins (NIM) were hit hard.  Most reported levels of both were below the last three quarters and some had levels below the last four quarters!  NIM drops varied but several were off as much as 80 basis points.  Damage was driven primarily from both higher interest costs and secondarily by mix shift.  Management guidance suggests most see an NII bottom in the third quarter while some were less certain.  Almost no guidance was available for 2024 at this time.

The Fed rate outlook was cited as the most relevant variable in projections.  At this time managments were expecting only one more rate hike this year, followed by a pause, and cuts beginning no sooner than the second quarter of 2024.  This is now broadly consistent with history.  When I looked at the last six Fed rate tightenings I found that it took an average of 37 months from the first hike to when inflation bottomed, suggesting that the current 2% policy target will not be reached until early 2025.  Separately, the first rate cut took place after an average of 22 months from the beginning of tightening, suggesting the first cut could be after the first quarter of 2024.  Finally most managements are expecting a cumulative cut between 100 and 150 basis points next year, suggesting some preservation of higher net interest margins than that during the period of ultra-low rates.  However, when rates do decline, it is logical to expect loan yields will decline before deposit costs, foreshadowing another period of NIM compression.

Managements, almost uniformly, expect either a mild recession or a possible soft landing.  I think this is still an optimistic reading as three variables have yet to impact the broader economy:  1) the typical delay from monetary tightening; 2) the likelihood of tightening bank credit, and; 3) the likely weakening in consumer spending following the depletion of pandemic savings.  On a year-over-year basis, spending has been below disposable income growth for the last five months.

Loan growth was still positive but dwindling during the quarter.  Most strength was in the commercial & industrial and commercial real estate sectors.  Loan funding was partially from investment securities runoff.  Also loan/deposit ratios have remained relatively low.

Credit quality remained high, with slight deterioration only in a few sectors such as office lending and home equity lines.  Disclosure in office exposure received the highest attention, although most have exposure in only mid-single digits to total loans.  A handful of office credits were classified albeit while still paying interest contractually.  Middle market loans also experience some modest migration to classified.  All indicated that total reserve levels were considered adequate and additions to loss reserves were more modest than in prior quarters.  I think it is too soon to know the ultimate damage overall.

All managments were queried about capital levels pending the release of “final” Basel guidelines.  Many are holding back on buybacks until more is known.  There are two noteworthy expectations.  First, the treatment of AOCI and, second, the increase in capital buffers.