Credit Quality Could Be Next Earnings Headwind

Posted by Paul Davis on Nov 29, 2023 11:05:00 AM


Credit quality will become a bigger part of the conversation as banks and credit unions head into the homestretch of 2023.

While credit metrics remain good by historical standards, we saw several regional banks announce what many characterized as “idiosyncratic” chargeoffs in the third quarter. They include a syndicated loan to an oil distributor that tripped up at least four banks and a participation tied to real estate that forced a New Jersey bank to charge off millions of dollars.

 Increased concern about more chargeoffs in a cooling economy, along with more scrutiny from regulators, will likely lead more financial institutions to keep boosting their loan-loss allowances – a cost that will put more pressure on management teams to find offsetting expense savings.

Knowing where to look for credit cracks, and having a better understanding of underlying exposure in 2024, can help executive teams determine how aggressive they should be with expense management elsewhere.

Nonaccrual assets rose by 13% in the third quarter from a year earlier, to $61.4 billion, according to the Federal Reserve. The banking industry’s aggregate loan-loss allowance was $190 billion on Nov. 8 – a 14% rise from a year earlier. 

Several areas bear watching when it comes to credit issues. 

Loan participations, where contractual relationships extend from a borrower to a lead bank and then to other lenders, and loan syndications, where each lender provides financing through a direct contractual relationship with the borrower, are worth watching based on the past quarter’s chargeoffs.

Commercial real estate, especially loans tied to office buildings, is another area of concern. CRE loan chargeoffs at U.S. banks rose four-fold in the second quarter from a year earlier, to $1.2 billion, according to the most-recent data compiled by S&P Global Market Intelligence. Roughly 40% of bankers surveyed by S&P said they expected CRE credit quality to deteriorate over the next year.

Consumer credit is also being watched due to lingering inflation and higher interest rates. The delinquency rate for consumer loans rose to 2.53% in the third quarter from 1.93% a year earlier, according to Fed data. Increased use of credit cards and Buy Now, Pay Later (BNPL) platforms could push those numbers higher.

Analysts and other industry observers are taking note.

While “credit quality remains excellent … losses and problem levels should see an uptick,” Chris Marinac, an analyst at Janney Montgomery Scott, wrote in a recent client note. Banks will continue to build reserves and absorb losses in the coming quarters, he said.

“It will initially be hard to discern if things are returning to some level of normal or weakening materially,” Hovde Group’s analysts wrote in a recent note to their clients, adding that they believe criticized loans will likely rise.

The Bottom Line

Any increase in credit costs will put incremental pressure on financial institutions to cut expenses elsewhere to meet their bottom-line targets. Credit modeling and watching for early signs of financial stress are critical steps to stay on top of credit cracks – helping you craft a strategy to meet your performance targets over the course of 2024.

Topics: Net Income, Credit Quality, Changeoffs, Loan-Loss Provision, Earnings, Risk Management

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