Even as the Federal Reserve raises interest rates to combat rising inflation, U.S. banks say they are protected from a deep recession that would spark notable loan losses, thanks to strong institutional risk management and a tight labor market.

While investors, executives and analysts focused on the banking space acknowledge that the Fed faces a difficult task in engineering an economic soft landing, they believe that even if a recession occurs, it will not pose a grave threat to U.S. banks.

This is the fourth part of a series of articles examining the prospects for a U.S. recession and the Federal Reserve's efforts to achieve a "soft landing" for the economy. Tomorrow's installment will preview the upcoming meeting of the Federal Reserve's Open Markets Committee. Part 1: US Fed aims for soft landing as economists see recession odds growing Part 2: As inflation soars, consumers brace for a hard landing Part 3: As cheap-money era ends, smaller companies face capital crunch Part 4: Risk management, low unemployment insulate banks in case of recession .

Fed rates are still relatively low in historical terms, currently sitting at just .83% compared to a peak of 5.31% in 2007 prior to the financial crisis and another of 2.41% in 2019 just before the pandemic, when the Fed began dramatically reducing rates in hopes of stimulating economic growth.

Rising unemployment figures are typically a major factor in recessions, but that is not happening right now, said Anton Schutz, president at Mendon Capital. Unemployment is just above the half-century low of February 2020, with the latest jobs report putting it at 3.6%.

Regulators have tightened bank oversight, and capital ratios are high. Banks have also generally avoided "stupid practices," such as negative amortization mortgages, witnessed in the years leading up to the Great Recession of 2008-2009, Schutz added.

"If there is a recession and if credit worsens, I expect the industry to do quite well and not have much in the way of issues," Schutz said. "I'm not terribly concerned about a recession and if we have one, I don't expect it to be deep."

Taming the beast

The Fed began raising interest rates in March as part of an effort to tame inflation which, in tandem with other indicators like a brief inversion of the yield curve in March, sparked a sell-off in stock markets amid speculation that a recession could be on the horizon.

Credit spreads, which have recently widened, indicate a stronger possibility of a recession, said Guy Lebas, chief fixed-income strategist at Janney Montgomery Scott. A simple regression of the change in credit spreads over the last six months and short-term interest rate curves suggest about a 40% probability of a recession — far from a certainty, Lebas said.

"There's obviously going to be some pockets here and there like commercial real estate, which is no longer as valued in a work from home world," Lebas said. "But that's a question of the value of the underlying assets, not higher rates or a slower economy."

Several of the chief executives of the nation’s largest banks suggested at Bernstein's 38th Annual Strategic Decisions Conference that a recession is looming, but banks are in a position to withstand a downturn.

JPMorgan Chase & Co. CEO Jamie Dimon said at the early June conference that a "hurricane" is on the horizon, but whether it will be a minor storm or Hurricane Sandy is still unclear. The PNC Financial Services Group Inc. CEO William Demchak said he also foresees a recession, but not a major disaster, and he expects the economy to recover without major credit losses. A recession would be "very manageable" for Citigroup Inc., said CEO Jane Fraser.

Fear itself

So far, the Fed's latest rate hikes have not led to an uptick in "criticized" loans, which comprise loans rated special mention, substandard, doubtful or loss, and which serve as early indicators for future credit problems. Criticized loans for the 20 largest banks in the U.S. peaked as the pandemic took hold in 2020 before sharply declining in 2021 and have remained flat since then, according to S&P Global Market Intelligence data.

While credit costs and rates of charge-offs, or debts that creditors have given up collecting payment for after several months of delinquency, may increase, they are unlikely to cause major problems, said Chris Marinac, director of research at Janney Montgomery Scott. The current environment is more like the dot-com bubble of the early 2000s, when valuations of tech companies without access to cheap funding cratered, than the 2008 financial crisis, Marinac said.

Credit cost estimates have risen along with recession fears, but the possibility of a major credit event is limited as credit has not exploded in recent years. The level of classified and criticized assets is much lower than 10 or 15 years ago, and disclosure requirements for these assets have become increasingly robust since the 1990s, Marinac said.

"I think if we had comparable data in 2007 and 2008, we would be shocked by how many loans were classified and criticized," Marinac said. "The problem is when you go back in time to the financial crisis, you didn't have comparable data."

Markets' pessimism notwithstanding, the Fed is unlikely to overshoot with interest rates and send the economy into a tailspin in the run-up to the midterm elections, Schutz said.

"I think people are in this dread and doom-and-gloom phase right in the middle of a really strong economy," Schutz said. "The Fed does not want to destroy the economy. Could they overshoot? Yes, but they are also a political animal."