More interest, more bankruptcies – banks prepare for hard times

New York, Frankfurt For months, the mix of energy crisis, high inflation, looming recession and war worries left the balance sheets of European banks almost untouched. Now major U.S. Banks have braced themselves more clearly than before for an economic slump, sending a warning signal to Europe.

That's because provisions for potentially bursting loans were a major factor in the outright collapse of net profits at major U.S. Institutions in the third quarter: JP Morgan earned 17 percent less on net, and the drop was even larger at Citi, down 25 percent, Morgan Stanley, down 29 percent, and Wells Fargo, down 31 percent.

Although the industry is benefiting from rising interest rates, particularly in the U.S. In return, a lot of investment banking revenue fell away. And tighter monetary policy, which allows for higher interest income, is also causing unease. The U.S. Federal Reserve (Fed) is raising key interest rates faster than it has in a long time to fight inflation.

The key interest rate is now on a range of three to 3.25 percent and could be raised another 0.75 percentage points at the upcoming meeting in early November. Concern is growing among bank executives and economists that the Fed will plunge the U.S. Economy into recession with its tough interest rate policy.

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Then loan losses would also rise, JP Morgan CEO Jamie Dimon indicated. Both consumers and companies are still in good shape. Consumers, a key driver of the U.S. Economy, "are spending 10 percent more than last year and 30 percent more than before the pandemic," Dimon told analysts. Still, he fears a "hurricane" on the horizon. "With inflation, rising prime and mortgage rates, volatile markets and the war, that will weigh on future results," he clarified.

The head of the largest U.S. Financial institution warns of a "hurricane" on the horizon: "Inflation, rising prime and mortgage rates, volatile markets and the war. That will weigh on future results," he said.

The institution's capital ratio was 12.5 percent and is expected to be 13 percent in the first quarter of 2023. The bank suspended a share buyback program to bolster its equity capital. "We hope to restart our buybacks early next year," Dimon stressed.

Mixed signals for Europe's banks

The quarterly results thus send mixed signals to European banks, which will not present figures until the coming weeks. Rising interest income, made possible by rate hikes from the European Central Bank (ECB) and the U.S. Federal Reserve (Fed), should be good news for institutions. The ECB has also been raising its key interest rates again since the summer. Top European bankers repeatedly point out that companies in Europe finance themselves more than in the USA via bank loans instead of the capital market.

In times of an economic downturn, however, banks are also threatened by higher burdens from bursting loans. This scenario is also feared by U.S. Financial institutions: the major bank JP Morgan, for example, built up more reserves for this danger in the third quarter by increasing its risk provision for defaulting loans by a total of $808 million. By comparison, a year earlier the bank had been able to release $2.1 billion in loan loss provisions it had set aside for the consequences of the corona pandemic. The release of these funds had additionally driven profits at the time.

The competitor Wells Fargo also formed additional provisions in the amount of 784 million dollars from July to September of this year. "We expect a steady increase in defaults and eventually credit losses, only the timing remains unclear," said group CEO Charlie Scharf. Citi increased its provision for loan losses by $370 million.

Institutions in Europe are also bracing for an economic downturn – making a necessary increase in risk reserves more likely. "We will not be able to escape a recession in 2023," Deutsche Bank chief Christian Sewing said in his role as president of the Association of German Banks (BdB) in Washington on the sidelines of the annual meeting of the International Monetary Fund and the World Bank. It also predicted more bankruptcies in the coming months.

The gloomy outlook is also making European banking supervisors nervous. "So far, the favorable interest rate environment has worked well for banks, but they need to remain vigilant with regard to developments in the risk outlook," ECB banking regulator chief Andrea Enria said at a recent meeting in Vienna. He wants banks to consider potential credit risks early on and deal with them proactively.

Steven Maijoor, the Dutch representative on the ECB's banking supervisory board, was even more outspoken: European banks should hold back on dividends and share buybacks to keep enough reserves for the expected economic downturn, he warned in an interview with the Bloomberg news agency published Friday.

Bank representatives such as Sewing and Karolin Schriever, a member of the board of the German Savings Banks Association (DSGV), on the other hand, are calling for politicians and regulators to relax certain rules so that banks can lend more with their existing equity capital.

Investment bankers are the big losers

The quarterly results of the US giants also mark a turning point in the balance of power between "Wall Street", i.E. The investment banking business, and "Main Street", i.E. The traditional banking business. Last year, investment bankers were still the stars of Wall Street. Now they are the big losers. That's because, in addition to rising provisions, the largely fallow mergers and acquisitions (M&A) business has been the second major drag on U.S. Banks' results.

Last year's M&A boom had helped make 2021 one of the most profitable years ever for the big Wall Street houses. This year, however, rising interest rates, geopolitical risks and fears of a global economic crisis have caused a slump in M&A activity. "Investment banking has been the business most negatively impacted by the economic environment with a lower appetite for mergers and acquisitions," explained Citigroup CEO Jane Fraser.

The largest U.S. Bank's investment banking revenue was down 47 percent from a year earlier.

Hopes that this business segment could recover in the second half of the year have not materialized, as the figures for the third quarter show. Investment banking revenue fell 47 percent at America's largest bank, JP Morgan Chase, 55 percent at Morgan Stanley and 64 percent at Citi. At Citi, the slump in M&A deals also caused net income to fall overall by nearly a quarter year-over-year to $3.5 billion in the July-September period.

This development is also a bad omen for European banks with large capital markets businesses, such as Deutsche Bank. However, at Germany's largest bank, revenue from bond and foreign exchange trading has traditionally played a far more important role than income from IPOs or merger advisory services. And it was in bond trading that revenues at major U.S. Banks JP Morgan, Morgan Stanley and Citigroup sputtered even more than the year before.

JP Morgan stock gains, Morgan Stanley loses

Investors, however, were not impressed by the setbacks in the third quarter. Shares of JP Morgan, Citi and Wells Fargo rose after the results were presented. That's because despite lower profits, at least JP Morgan, Citi and Wells Fargo beat analysts' expectations. This was also due to the fact that the institutions were able to partially compensate for the lull in investment banking in other areas.

JP Morgan and Citi generated higher net interest income thanks to their large retail banking business. Gerard Cassidy, an analyst at RBC Capital Markets, expects institutions to "continue to benefit from high interest rates and increasing demand for loans throughout the first half of 2023".

At JP Morgan, net interest income rose 34 percent year-on-year to $17.6 billion – a new record. For the year as a whole, net interest income could be 61.5 billion dollars, according to the bank – 3.5 billion higher than initially assumed.

"JP Morgan's results were surprisingly good," praised Octavio Marenzi of capital markets consultancy Opimas. The fact that net income fell by 17 percent was mainly due to higher risk provisioning, it said. "If you strip that out, then profits are on par with last year's." Sales increased by ten percent thanks to rising prime rates.

Morgan Stanley, on the other hand, had begun to expand its asset management business after the financial crisis in order to ensure a more stable flow of income. Asset management revenues increased by three percent in the quarter and contributed almost half of the Group's total revenues. Nevertheless, the share lost value on Friday. While firm CEO James Gorman assessed his company's performance as "robust and balanced in an uncertain and challenging environment". Analysts, however, had hoped for a better earnings situation.

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