Bank Reserves at 1.75% Signal Economic Caution, KBE Up 7.5%

Key Takeaway

• Banks' loan loss reserves are at 1.75% of loans, above the pre-Covid average, indicating preparedness for a recession that hasn't occurred.
• A potential slowdown or reversal in loan loss provisioning could boost bank earnings, with the SPDR S&P Bank ETF (KBE) already up 7.5% in May.
• The economic outlook and commercial real estate pressures remain risks, but overall bank earnings show resilience amidst an inverted yield curve challenge.

Banks Brace for Recession That Never Came

In anticipation of a recession that ultimately did not materialize in 2023, banks significantly bolstered their balance sheets. Loan loss reserves surged to approximately 1.75% of loans outstanding, a notable increase from the pre-Covid average of 1.20-1.25%, as reported by MRB Partners. This conservative approach, partly driven by regulatory encouragement, aimed to preempt potential loan losses, which, as Bob Elliott from Unlimited Funds noted, "largely haven’t materialized." The first quarter saw bank earnings surpass expectations, with the SPDR S&P Bank ETF (KBE) reflecting a positive uptrend in May, marking a 7.5% increase month to date.

Economic Resilience and Bank Earnings

Despite the inverted yield curve, which typically challenges bank profitability by making short-term borrowing costs higher than long-term lending rates, the outlook for bank earnings remains resilient. MRB strategist Salvatore Ruscitti and Lauren Goodwin from New York Life Investments highlighted the potential for banks to improve quarterly earnings by reducing loan loss reserves, given the absence of significant loan losses, particularly in the office real estate sector. However, the sustainability of bank profitability remains under scrutiny due to the persisting inverted yield curve.

High Interest Rates Impact on Americans

The Federal Reserve's high interest rates, while not triggering the feared financial system crash or widespread bankruptcies, have disproportionately affected low- and moderate-income families. Increased borrowing costs have exacerbated financial pressures for these households, struggling with high prices, dwindling savings, and slow wage growth. The narrative of Ora Dorsey, a 43-year-old Army veteran, exemplifies the challenges faced by many Americans, as she juggles multiple jobs to manage her debt amidst rising interest rates.

Street Views

• Bob Elliott, Unlimited Funds (Neutral on the banking sector):

  "From some prodding from the regulators, as well as some conservatism from the leadership of many banks, they pre-provisioned on the risk that there might be more substantive loan losses. And those just largely haven’t materialized."

• Salvatore Ruscitti, MRB Partners (Cautiously Optimistic on bank earnings):

  "Banks could even draw down their reserves as charge-offs materialize if they become confident that the worst of the loan losses associated with office real estate are behind them and there is no significant contagion to other property markets."
  "In our view the market’s initial focus on the lack of upside surprises in [net interest income] was shortsighted and missed the more important takeaway, which is that the outlook for overall bank earnings is one of ongoing resiliency."

• Lauren Goodwin, New York Life Investments (Cautious on bank profitability):

  "It’s hard to know what enough [reserves] is. I think the challenge for banks is that as long as the yield curve is inverted, it’s just really hard to be profitable."