Spiking interest rates and strong lending have set banks up to post another period of revenue growth in fourth-quarter 2022 earnings reports. But analysts have turned increasingly bearish on the sector over expectations for credit loss reserve builds ahead of a potential recession, as well as a catch-up in deposit costs that may soon put a stop to the net interest income bonanza.

"We seem to be nearing the end of this just explosive expansion in [net interest] margins and almost straight up move in [net interest income]," Piper Sandler analyst R. Scott Siefers said in an interview, noting that the surge is likely to create favorable year-over-year comparisons for full year 2023. But "investors will focus much less on the fourth quarter's actual results than they will on the outlook."

Analysts have penciled in sequential increases in earnings per share at 10 of the 17 publicly traded U.S. banks with more than $100 billion in assets, according to consensus estimates compiled by S&P Global Market Intelligence. That includes revenue increases at 12 of them, partially offset by credit loss provision increases at about the same number.

The shift in analysts' outlooks puts sell-side sentiment closer to that of investors, who have assigned banks low earnings multiples relative to the broader market. But analysts are divided on how much of a cushion the discount provides for potential cuts to consensus earnings forecasts as banks update guidance.

Investors need a "clearing event … for fund managers to revisit the group," BofA Global Research analyst Ebrahim Poonawala said in a note on Jan. 5, observing that bank stocks have in past cycles tended to bottom a little before trough macroeconomic conditions and peak credit deterioration.

Credit costs getting worse

Consensus forecasts anticipate a median sequential increase of 14.1% in fourth-quarter credit provision expenses across the big bank group, which would also represent a swing from negative provisions — equating to reserve releases — for the majority of the companies the year prior.

Accounting rules require banks to set aside for credit losses based on changes in the macroeconomic outlook, before actual credit losses materialize, which can occur with a considerable lag. So far, net charge-offs have barely moved up from post-pandemic lows, and consensus forecasts for the big banks expect only a median increase of 4 basis points to a still-benign median of 20 basis points in the fourth quarter.

"Whatever cycle we are entering seems to be occurring in slow motion," Siefers said.

Ultimate credit losses will be driven by a range of unknown factors like the path of unemployment — which hit a cycle-low of 3.5% in December — but some analysts have projected a sharp provisioning cycle.

Jefferies analysts expect provisioning to be heavily front-loaded, with the average allowance coverage ratio for its large-cap banks increasing 53 basis points from the third quarter of 2022 to 2.15% at the end of 2023 — about half the distance to the group's pandemic peak — before falling to 1.73% at the end of 2024 even as net charge-offs continue to rise.

Peak coverage ratios should be achieved in the first half of 2023, Jefferies analyst Ken Usdin said in a note on Jan. 9, which "could set the stage for good entry points" for stocks.

Time to pay the piper a better deposit rate

The analyst consensus expects net interest margins for the big bank group to expand by a median 12 basis points sequentially in the fourth quarter, a slowdown from the median increase of 27 basis points in the third quarter.

Analysts also expect NIMs to top out soon as the Federal Reserve approaches the end of its hiking cycle. Surging asset yields could "cease abruptly," Siefers said in a Jan. 3 note, while pressure on deposit costs from outflows and competition persists.

"What looked a year ago like several years' worth of excess liquidity has quickly become a brawl to keep everything that is left," the analyst said.

Rising rates drove earnings estimates higher in 2022, Christopher McGratty, head of U.S. bank research for Keefe Bruyette & Woods, said in an interview. But as the Fed's policy rate moves past 4% and toward 5%, the incremental benefit for banks shrinks and "the margins eventually will roll over."

A cooling economy is also likely to dampen loan growth, limiting another revenue stream.

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After the storm

While things can appear bleak on the precipice of a potential hard landing, BofA Global Research's Poonawala said he is bullish on the sector over the medium term. He cited factors like structurally higher interest rates compared to the past decade that can advantage core deposit franchises and risk transfer to nonbanks that could make a credit cycle more manageable for banks.

In a Jan. 3 note, KBW said it cut its "outperform" ratings on U.S. banks from 50% of its coverage at the end of 2021 to 36% at the end of 2022.

But McGratty observed that there is considerable uncertainty after the "record speed" at which the Fed has raised rates.

"The range of outcomes today is so pronounced," he said. "People haven't seen a traditional recession in 20 years."