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Overall, the financial sector appears well positioned for an economic downturn. Arguably, the predicted recession has been one of the most forecasted in economic history. As such, financial institutions have had plenty of time to prepare their balance sheets accordingly, which they have.
We are unlikely to see the negative feedback loop seen in many recessions of people losing jobs, defaulting on debt, and causing financial institutions to tighten more on credit conditions to maintain their capital ratios in accordance with regulatory requirements (slowing the economy further).
Loan Demand
Both banks and credit unions have seen new loan originations ebb as rising interest rates and tighter lending standards cool demand. Credit unions saw a significant drop-off in Q1 2023 compared to the same quarter the previous year.
![Loan_Demand[1]](https://blog.swbc.com/hs-fs/hubfs/Loan_Demand%5B1%5D.png?width=1380&height=686&name=Loan_Demand%5B1%5D.png)
The last quarter of positive loan origination growth was Q3 2022, which saw a very modest 2.3% year-over-year growth. We expect these trends to continue throughout the duration of 2023, further slowing demand and the economy more generally.
Net Interest Margins
While net interest margins continue to decline with cost of funds increasing, credit unions have thus far been able to maintain their margins. A negative net interest margin for banks in Q1 2023 is part of the inverted yield curve and credit tightening. This will likely continue to be a challenge for both banks and credit unions as we move into the second half of the year.
![Net_interest_Margins_2[1]](https://blog.swbc.com/hs-fs/hubfs/Net_interest_Margins_2%5B1%5D.png?width=1380&height=686&name=Net_interest_Margins_2%5B1%5D.png)
![Net_Interest_Margins_1[1]](https://blog.swbc.com/hs-fs/hubfs/Net_Interest_Margins_1%5B1%5D.png?width=1380&height=647&name=Net_Interest_Margins_1%5B1%5D.png)
Asset Ratios
Asset ratios have deteriorated somewhat to levels last seen in 2008. Most of this deterioration can be attributed to unrealized losses on investment securities (mostly government bonds) that lost value as rates rose dramatically during 2022 and are not a reflection in overall performance. In fact, banks saw an uptick in Q1 2023 as many of these assets regained some value.
![Asset_Ratios[1]](https://blog.swbc.com/hs-fs/hubfs/Asset_Ratios%5B1%5D.png?width=1380&height=642&name=Asset_Ratios%5B1%5D.png)
Delinquencies and Insurance Coverage Lapses
We are continuing to see the deterioration in delinquencies and charge-offs we have been forecasting. Banks are seeing the biggest increases in credit cards and commercial real estate (particularly for office space), and credit unions are seeing an uptick in delinquencies on credit cards and consumer loans (autos).
While these levels are still nowhere near their pre-pandemic levels, it is clear consumers are struggling to keep up. We expect this to continue as long as inflation remains high and interest expenses increase for both consumers and businesses.
We have also noticed a significant uptick in insurance coverage lapses on autos. This is often a precursor to deterioration in delinquencies and further reflection of the stress consumers are under. As this trend continues, we expect delinquencies to continue rising in the coming months.
The good news is that the financial industry seems well prepared for this impending deterioration in loan performance. Both banks and credit unions have increased their loan loss reserves over the past year.
Conclusion
Overall, the combination of slower loan growth, tightening interest margins, and rising delinquencies/charge-offs will challenge financials institutions’ profitability for 2023 and likely in 2024. Despite this, the sector seems well prepared for the pending economic slowdown. The Federal Reserve’s actions to provide liquidity to the industry should be more than enough to deal with any challenges that emerge from the rapidly rising rate environment and slowing economy.
Recommendations for Financial Institutions
- Be prudent with lending activities (LTV ratios) and expect loan demand to be challenged as 2023 unfurls.
- Ensure collections activities are prepared for any uptick in activity.
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