Credit Musings: October 17, 2023

Oct 17, 2023


Public Trust Credit Team

Israel is currently rated AA- and their “stable” outlook was recently affirmed by S&P at the end of July, despite ongoing political unrest and sizeable public protests over judicial reforms at the time.

The recent conflicts, however, have taken unrest to levels well above agencies’ base cases, and the sole downgrade trigger in S&P’s most recent review stated, We could lower the ratings if regional or domestic political risks escalated sharply.* A significant risk would be the potential escalation into direct conflict with neighboring countries in the region, particularly Iran and Lebanon, which could send Israel’s already slowing economy into a severe contraction. Economic spillover effects are difficult to quantify, but according to S&P “several credit factors could be impaired simultaneously, including economic growth, the balance of payments, and fiscal performance.* Some of the strengths supporting Israel’s current rating include its wealthy and diversified economy; flexible monetary policy; and a relatively deep pool of domestic savings although the benefits of these are also likely to be impaired below agencies’ pre-conflict expectations, at least in the short term. Overall, it is our view that negative rating action seems highly likely due to the numerous detrimental impacts of destabilization, though the extent is difficult to predict and depends largely on if and how severely the current conflict escalates. 

CRE, Basel III, and Net Interest Income Makes Three. U.S. Bank Q3 Earnings Preview.

US banks began reporting their earnings last week and we have a busy week of U.S. bank earnings ahead of us. Here is what the Credit Team is looking for in Q3 earnings.

Asset Quality and CRE: Credit quality at the U.S. banks has remained remarkably robust against the shocks of this year. Non-performing loans have shown little sign of deterioration and commercial credit has performed well. There is evidence that U.S. savings have been declining for a few months, so we are looking to see if lower savings have yet pushed through to delinquencies. From the earnings reported on Friday, all four banks including JPM, Wells Fargo, Citi, and PNC, posted strong asset quality and reported only mild normalization in quality metrics – which suggests that trend will continue through the rest of the bank’s earnings. However, both Wells Fargo and PNC reported sharp increases in non-performing loans related to their office commercial real estate (CRE) exposure. The largest U.S. banks have mild exposure to CRE, but Wells and PNC have some of the largest exposure of the cohort, so an uptick in CRE charge-offs may be telling. We expect it will take a while to work through issues in office CRE, but the results this quarter are one of the clearest signs we’ve seen of deterioration in the asset class at large banks.  

Capital: The banks who have reported thus far have all shown consecutive increases in their regulatory capital, which is a trend we expect to see across the largest U.S. banks. Banks are building capital in anticipation of the Basel III Endgame proposal that was released over the summer that would sharply increase the level of risk-weighted assets (RWAs) the banks hold. We expect the banks to show increases in capital and lower shareholder returns as necessary to build appropriate regulatory buffers. However, we don’t expect the banks to have to pursue capital raises given the long runway before rules are phased in.

Profits: Net interest margins (NIM) should be approaching their peak, assuming they haven’t peaked already. The banks have had several quarters to absorb rate hikes and now funding costs and deposit costs are beginning to eat into NIM’s. Most banks have reported higher deposit costs going forward and anecdotally have mentioned the need to give high rates to attract new deposits, offsetting interest income from lending. Despite pressures on the NIM, loan volumes are still chugging along and 2 of the 4 banks that have reported so far have increased their year-end guidance for net interest income (NII). In addition, the environment for capital markets appears to be easing with several new transactions announced or closing and a volatile market environment providing tailwinds we hope to see across the cohort. 

Takeaways: U.S. banks continue to show strength and we expect this trend to continue through Q3 earnings. Loan volumes look good but are offset by pressure on NIMs which we believe are close to their peak. The environment for non-interest income appears to be improving, which should offset some of the NII pressure moving forward. Expenses remain a sticking point among the banks with PNC announcing a new cost savings initiative and all the banks expected to report progress reigning in expenses while also dealing with a persistently strong wage environment. Across the cohort regulatory capital levels are set to build ahead of the Basel III Endgame proposal, though we do not believe any of the largest banks will need to raise capital in the market. Finally, asset quality remains strong, especially in consumer lending; but we did see a sharp uptick in non-performance related to office CRE lending at Wells and PNC, which could provide insight into the breadth of the downturn.

**Source: “Israel Ratings Affirmed at ‘AA-/A-1+’; Outlook Stable.” S&P Global Ratings, 12 May 2023,

All comments and discussions presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses. 

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