The Big Idea

Out-of-consensus calls on 2023 bank balance sheets

Tom O'Hara, CFA | November 18, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

An expected recession early next year would likely turn the tables on some of the impressive forces now shaping bank balance sheets. Loan demand would likely fall, pressure on bank capital and liquidity ease. And a downshift or end to Fed rate increases might slow a rising cost of deposits and reduce bank demand for wholesale funding. But with a strong case for recession only coming in late 2023 or 2024, key trends on bank balance sheets have momentum through most of next year.

The case for continued growth through most of next year leads to five calls outside the consensus on 2023 US bank balance sheets:

Loan growth continues
Securities portfolios continue to shrink
Deposits continue to decline
Growth of wholesale funding continues
Banks reduce the pace of asset coupons resetting faster than liabilities

Loan growth continues

Loan growth has taken off as the US has emerged from Covid, and it should continue its upward trajectory with recession likely holding off next year (Exhibit 1).

Exhibit 1: Loans to continue their upward trend of the past 12 months

Source: Federal Reserve H.8, Amherst Pierpont Securities, Loans and leases in bank credit, all commercial banks, s.a.

Much of this growth, roughly 30%, has come in commercial and industrial (C&I) loans (Exhibit 2). C&I loan demand—outside of a surge in PPP lending—basically stopped during 2020 and 2021 as many businesses struggled to survive, much less expand, throughout various local lockdowns and quarantines. Once the economy started to emerge from pandemic, the pent-up demand made C&I lending a growth area. This should continue in 2023.

Exhibit 2: Post-pandemic demand for C&I loans continues to grow

Source: Federal Reserve H.8, Amherst Pierpont Securities, Commercial and industrial loans, all commercial banks, s.a.

To a lesser extent, 2022 also saw growth in various consumer loans including credit cards (Exhibit 3). Consumer loans have accounted for roughly 17% of loan growth so far in 2022 with cards being more than 70% of this category. While recession may not materialize in 2023, the consumer’s liquidity should start to drain as they experience more stress from inflation, and credit card balances should grow even faster than they did in 2022.

Exhibit 3: Inflation and economic pressure will drain consumer liquidity and credit card balances will continue to grow

Source: Federal Reserve H.8, Amherst Pierpont Securities, Consumer loans: credit cards and other revolving plans, all commercial banks, s.a.

Residential mortgage loan growth has accounted for about 15% of total loan growth so far this year but has now slowed down significantly (Exhibit 4). Even if this category were to not grow at all in 2023, sustained growth in the other loan types, already accounting for the vast majority of production, should keep overall volumes strong.

Exhibit 4: Residential mortgage production stalling out

Source: Federal Reserve H.8, Amherst Pierpont Securities, Residential real estate loans, all commercial banks, s.a.

Short of a recession, in addition to some stress on consumer liquidity, provisions for credit losses should continue to increase in 2023. Banks swung from releasing provisions in the last quarter of 2024 to progressively adding more provisions in each quarter of 2022 (Exhibit 5). While some of this increase will be based on a deteriorating economic outlook, much of it will just be attributable to the sheer growth of the loan book as it has been in 2022.

Exhibit 5: Loan loss provisions progressively increasing

Source: S&P Capital IQ, Amherst Pierpont Securities.

Securities portfolios continue to shrink

As most loan types—other than residential mortgage—should continue to grow in 2023, banks will need to make room on their balance sheets for these assets as they did in 2022 (Exhibit 6). Additionally, deposit outflow that is not replaced by wholesale funding—more on that later—will also require the reduction of more liquid assets such as securities. For any amount of securities portfolio reinvestment that banks are pursuing, they should continue to lean toward 0% risk-weight alternatives such as Ginnie Mae securities given that their capital ratios will remain under pressure due to the increase in higher risk-weight (100%) loans.

Exhibit 6: Securities: No room at the inn

Source: Federal Reserve H.8, Amherst Pierpont Securities, Securities in bank credit, all commercial banks, s.a.

Deposits do not stop their outflow trend

Deposit balances rose going into 2022, became choppy in the first half of the year, and began falling in the third quarter (Exhibit 7). Certainly Quantitative Tightening, at an estimated $80 billion a month in combined Treasury and MBS run-off, takes close to a trillion dollars of liquidity out of the system annually. As the Fed struggles to contain inflation and continues to hike into 2023, incremental deposit betas should progressively increase, but so will the yields of alternative cash investments. Some deposits will flow out the system and push banks toward more wholesale funding alternatives.

Exhibit 7: Rising rates make deposits more expensive and more difficult to retain

Source: Federal Reserve H.8, Amherst Pierpont Securities, Deposits, all commercial banks, s.a.

Growth of wholesale funding continues

While banks replaced some of deposit run-off with other forms of funding, much of it was not. Bank cash balances still declined 2022 (Exhibit 8). Banks had significant excess liquidity at the start of the year, with loan-to-deposit ratios in the mid-to-high 60%s for the APS tracking group compared to a historical average closer to 90%. Banks watched some of these deposits leave the system, but now that their loan-to-deposit ratios are closer to 80%, they will need to fight harder to keep deposits in-house to maintain adequate liquidity and not watch their cash continue to drain lower.

Exhibit 8: Much of the deposit funding has not been replaced, cash balances decline

Source: Federal Reserve H.8, Amherst Pierpont Securities, Cash assets, all commercial banks, s.a.

Allowing cash to decline has obvious limitations as banks will need to maintain their liquidity pools, and wholesale forms of funding will increase even more so than seen in 2022 (Exhibit 9). Unsecured debt, securitization, FHLBank funding and repurchase agreements should all play a more prominent role in 2023.

Exhibit 9: Wholesale funding will need to replace a larger percentage of deposit run-off in 2023

Source: Federal Reserve H.8, Amherst Pierpont Securities, Other liabilities, all commercial banks, s.a.

Banks reduce the pace of asset coupons resetting faster than liabilities

Given that most banks are still very asset sensitive—asset coupons rising faster than liability coupons (Exhibit 10)—many started to take steps in 2022 to reduce this sensitivity in anticipation of, and a hedge against, lower interest rates and a reduction in net interest income. With recession expected but not imminent, banks should continue to take steps to incrementally reduce asset sensitivity by adding duration. These steps should become more pronounced as the year progresses.

Exhibit 10: Banks still positioned for higher rates

Source: S&P Capital IQ, Amherst Pierpont Securities, 22Q2

Tom O'Hara, CFA
thomas.ohara@santander.us
1 (646) 776-7955

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