Four of the United States’ largest global systemically important banks (GSIBs) report earnings this Friday, October 14thth: Citigroup
When analyzing banking earnings, it’s important to remember that banks make money in three ways: net interest margin, trading, and fees from services like investment banking and wealth management. The most volatile of these three categories is trading income, as it is heavily influenced by sovereign risk, macroeconomics, fiscal policy, geopolitical risk, and natural disasters, which can heavily impact interest rates, foreign exchange rates, commodity prices, and security prices.
Currently, the rising interest rate environment could help some banks increase their net interest margin as they now charge more for new loans and loan products they approve. Banks’ median net interest margin increased in the second quarter of 2022 compared to the same period in 2021. Banks should benefit from a significant increase in consumer credit, which I recently wrote is at record highs.
However, it is feared that rising interest rates will make it harder for borrowers to repay their outstanding loans, especially when those lending products such as credit cards are variable rate products. When bank earnings are released over the next two weeks, we should see what percentage of loans, also known as non-performing loans (NPLs), are starting to deteriorate. These are loans whose borrowers are ninety days or more in payment. As NPL levels rise, we should also consider whether banks are increasing their loan loss provisions, aka provisions; An increase in loan loss provisions means that a bank is preparing for borrower defaults. The loan loss reserve is a non-cash deduction on the income statement. Therefore, if banks are cautious, we are likely to see an increase in credit risk reserves to prepare for the proverbial “rainy day” that will potentially result in a decline in net profits, particularly for banks that depend on net interest margin rather than trading and fees . At the end of the second quarter of 2022, write-offs were stable. Banks typically write off loans after borrowers are more than 180 days past due.
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Where banks could really take a hit is in their trading and fee divisions, particularly investment banking and wealth management. Asset price volatility, largely driven by uncertainty about whether the Federal Reserve can control inflation and when the Russian invasion of Ukraine will end, is likely to weigh on banks’ trading earnings and asset management fees. A decline in mergers and acquisitions will also weigh on investment banking fees. Banks like Morgan Stanley and Goldman Sachs, whose revenues depend largely on trading income and investment banking and wealth management fees, are likely to take a hit; They’re not as diversified as JPMorgan Chase and Citigroup, which have sizeable loan books, trading and fee-generating businesses.