Home Banking Higher Loan Loss Provisions Demonstrate Credit-Quality Concerns at US Banks

Higher Loan Loss Provisions Demonstrate Credit-Quality Concerns at US Banks

by internationalbanker

By Hilary Schmidt, International Banker


With the Federal Reserve’s (the Fed’s) dramatic cycle of monetary tightening still not over and the threat of the US entering a recession later this year or in 2024 highly credible, US banks continue to allocate ever-greater provisions to address potential loan losses. In so doing, there is widespread acknowledgement that further credit deterioration is coming.

The largest American banks nonetheless reported strong earnings for the second quarter, demonstrating how beneficial higher interest rates have proven to be in bolstering lending activity and net interest margins (NIMs). But with the expirations of a raft of government-backed measures that supported vulnerable households and businesses during the pandemic threatening a seismic wave of loan defaults, lenders are becoming increasingly concerned about how adversely those rising interest rates are impacting borrowers as the central bank continues struggling to bring inflation down to its formal target of near 2 percent.

According to S&P Global Market Intelligence, loan loss provisions (LLPs) have increased sequentially at almost two-thirds of the 25 financial institutions included in its recent analysis of lenders with at least $10 billion in assets that reported second-quarter earnings by July 28. At the top end of the scale—those with more than $50 billion in assets—Bank of America (BofA) reported provision expenses of $1.13 billion, including building up $256 million in reserves. “The provision expense reflects the continued trend in charge-offs toward pre-pandemic levels, and it’s still below historical levels,” BofA’s chief financial officer (CFO), Alastair Borthwick, said during an earnings call. And although Citibank lowered its loan loss provisions by $141 million from the previous quarter, the allowance still stands at a mammoth $1.81 billion.

As for JPMorgan Chase, all eyes were on how its government-backed acquisition of failed lender First Republic Bank amidst torrential banking-industry instability would play out. And even though the US’ biggest bank reported earnings of $14.5 billion and revenue of $41 billion (67 percent and 34 percent more, respectively, than a year ago), it also set aside $2.9 billion in provisions to cover future loan losses (excluding First Republic, the provision was $1.7 billion, reflecting net charge-offs of $1.4 billion and a net reserve build of $326 million). This allocation was a whopping 163 percent more than a year ago, underscoring the sheer extent of the challenges faced as the US economy is expected to slow over the next few quarters.

Looking at the lowest rung of US banks that S&P included in its analysis—those with assets between $10 billion and $20 billion—provisions for this cohort mostly increased during the April-June period. Using the example of Sandy Spring Bancorp, S&P noted that the Maryland-based lender recorded the largest sequential increase in LLPs between the first and second quarters, from a negative provision of $21.5 million to a positive $5.1 million, which according to its chairman, president and chief executive officer (CEO), Daniel J. Schrider, was primarily driven by a multifamily construction loan in the low-$20 million range. “Our review of the broader multifamily portfolio does not indicate any similar trends within other relationships,” Schrider said during an earnings conference call, adding that the borrower is facing cash-flow challenges because of low occupancy.

And in the mid-sized range of $20 billion to $50 billion in assets, SouthState Corp.’s second-quarter provision of $38.4 million was reportedly driven by a change in the commercial real-estate price index forecast. According to CFO William E. Matthews, the Florida-based lender is building loan-loss reserves “in the face of a possible recession”.

Many lenders highlight commercial real estate as arguably the industrial sector representing the most problematic source of bad loans in the United States. Specifically, those exposed to offices face a distinctly deteriorating outlook amid higher borrowing costs and lower demand for office space underpinned by redundancies and growing preferences for remote-work arrangements. A report from Bloomberg recently noted that some office owners are already defaulting on loans in attempts to commence renegotiations with lenders.

According to the Mortgage Bankers Association (MBA), moreover, about $189 billion in debt on US office real estate will need to be extended or refinanced this year, half of which was borrowed from banks, while Green Street estimates that US office prices have fallen by a sizeable 31 percent through June from their 2022 peak. “As lenders, banks can always do loan workouts with problem loans,” Kenneth Leon, a bank analyst at CFRA (Center for Financial Research and Analysis) Research, wrote in a note to clients just prior to the release of the banks’ second-quarter (Q2) earnings, “although certain individual office buildings may be challenging to remedy”.

Indeed, US banks have become decidedly wary of this specific exposure. For instance, offices represent about 22 percent of Wells Fargo’s outstanding commercial-property loans, although the bank recently told Bloomberg that major losses have yet to materialise. “The losses are still quite small. We do expect that there will be more weakness in the market, and it’s going to take a while to play out,” CFO Michael Santomassimo confirmed on July 14. Wells Fargo’s president and CEO, Charles W. Scharf, similarly affirmed in an earnings call that while significant losses in the office portfolio were not incurred during the second quarter, the bank’s “detailed loan-by-loan review of the portfolio has given us a sense of how the next several quarters could play out…. We also considered a number of stressed scenarios, all of which informed our actions this quarter”.

Thus, it has become patently clear this year that banks are preparing for a continued rise in soured loans. Perhaps the clearest indicator of this growth can be found in the number of corporate-debt defaults so far this year, with the first six months having already eclipsed the total number of defaults in 2022. According to data published in July by Moody’s Investors Service (MIS), 55 US-based companies defaulted on their loans during the first half of this year, 53 percent more than the 36 company defaults logged throughout 2022.

And with this harsh credit environment only set to become tougher as the likelihood of a pronounced recession grows, Bank of America stated it expects almost $1 trillion of corporate-debt defaults to materialise this year, while estimates from Deutsche Bank in late May suggested that US loan defaults could rise to 11.3 percent, just shy of the 12 percent observed during the 2088 Global Financial Crisis (GFC). “Our cycle indicators signal a default wave is imminent. The tightest Fed and ECB [European Central Bank] policy in 15 years is colliding with high leverage built upon stretched margins,” Deutsche Bank analysts noted, adding that defaults are a “near-term risk” over the next six to twelve months.

Indeed, looking out across the next few quarters and well into 2024, there is little to suggest that loan losses at US banks will not continue to grow. “Risks may be more pronounced if the U.S. enters a recession—which we expect will happen in early 2024—because asset quality will worsen and increase the potential for capital erosion,” Moody’s reported on August 7, having cut the credit ratings of 10 small and mid-sized US banks by one notch while placing under review for potential downgrades additional major financial institutions, including Bank of New York Mellon (BNY Mellon), U.S. Bancorp, State Street, Truist Financial Corp (TFC), Cullen/Frost Bankers, Inc. (CFR) and Northern Trust. Moody’s also changed its outlook for an additional 11 banks from stable to negative, including Capital One Financial Corporation, Citizens Financial Group and Fifth Third Bancorp. “We continue to expect a mild recession in early 2024, and given the funding strains on the US banking sector, there will likely be a tightening of credit conditions and rising loan losses for US banks,” the credit-rating agency added.

US banks also continue to contend with interest-rate and asset-liability management risks with implications for liquidity and capital “as the wind-down of unconventional monetary policy drains systemwide deposits and higher interest rates depress the value of fixed-rate assets,” Moody’s analysts Jill Cetina and Ana Arsov observed in an additional research note issued at the time. “Meanwhile, many banks’ Q2 results showed growing profitability pressures that will reduce their ability to generate internal capital. This comes as a mild US recession is on the horizon for early 2024, and asset quality looks set to decline from solid but unsustainable levels, with particular risks in some banks’ commercial real estate (CRE) portfolios.”

But with net interest margins driving significant profitability across much of the sector, many still contend that the higher loan losses for which US banks are now allocating remain comfortably outweighed by the positives yielded by higher interest rates. The biggest banks “have been a good place for investors to hide amid liquidity concerns for regional banks coupled with concerns regarding increased regulations,” KBW (Keefe, Bruyette & Woods) bank analysts Christopher McGratty and David Konrad wrote in a recent note to clients. “That said, it remains a challenging environment for the universal banks.”


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