The U.S. banking industry's early warning indicator for credit stress continued to signal improvement in the second quarter.

Criticized loans fell quarter over quarter at 20 of the 28 U.S. banks with more than $50 billion of assets for which values are available, according to data from S&P Global Market Intelligence. The drop extended a consistent decline in criticized loans across large banks following a pandemic-induced surge that peaked in 2020, and pushed the median ratio of criticized loans to Tier 1 capital to below levels seen in 2016 and 2017.

Criticized loans are regarded as a leading indicator of credit trends because they include commercial loans that banks flag as having an elevated risk of default per their internal ratings, as well as loans that have already missed payments. The data aligns with reports from banks that have said they have not yet seen many concrete signs of credit deterioration, despite a slowdown in economic activity and fears that higher interest rates could trigger a severe downturn.

Still, banks have been tightening loan standards and executives say they are keeping a particularly close eye on areas like offices and health care properties. Analysts anticipate that higher interest rates alone will prompt some business defaults.

M&A-related increases

Among the eight banks that reported higher levels of criticized loans, three completed major acquisitions during the second quarter. M&T Bank Corp. said its increase was driven by its purchase of People's United Financial Inc., while Citizens Financial Group Inc. said its was driven by its deal for Investors Bancorp Inc.

M&T said its criticized portfolio reflects ongoing damage from the pandemic, with about 58% of its criticized loans in the investor-owned commercial real estate sector. The bank also said some commercial borrowers have been pressured by an inability to pass on rising prices to customers, although it maintained its guidance for a net charge-off rate in the 20-basis-point range this year.

"I wouldn't give the all-clear signal. That would be very un-M&T like," CFO Darren King said on an earnings call. "But there's nothing that's flashing red right now that says that there's a big crisis coming in the next several quarters."

Bank of America Corp. reported declines in criticized loans for the quarter and the first half of the year despite downgrades of its Russia exposure. The bank said the declines were "broad-based across industries."

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Recovery to pre-pandemic levels

Across the 100 biggest publicly traded banks in the U.S., aggregate criticized loans have fallen 31.1% to $156.16 billion in the second quarter of 2022 from $226.71 billion at the end of 2020. The second-quarter total remains above a 2016 to 2019 pre-pandemic range of $106.37 billion to $122.99 billion, but bank loan portfolios have grown substantially since then.

The median ratio of criticized loans to Tier 1 capital has fallen to 17.6% from 30.3% at the end of 2020. That is below the middle of the range of 16.8% to 19.4% from 2016 to 2019.

Early warning signals are a bit less reassuring elsewhere, but are not signaling any major imminent problems. The credit spread for the ICE BofA US High Yield Index, which can serve as a proxy for market sentiment on commercial bank loans, reached almost 6% in early July, though the spread entered September at about 5%. That compares with a peak of nearly 11% early in the pandemic and a peak of nearly 9% during a rough patch in the economy in 2016.

Leveraged debt analysts at BofA Global Research said they expect defaults to rise over the next two to three years, but borrowers are entering the cycle in a relatively stronger position after refinancing into higher levels of fixed-rate debt.

"We do not anticipate an aggressive default cycle," they said in an Aug. 29 note. Instead, under a stagflation scenario, they expect "a reset higher of baseline attrition."