US banks deliver continued growth in Q3 amid rising rates and geopolitical uncertainties

Despite an anticipated interest rate hike and mounting geopolitical uncertainties, consumers and the economy remained surprisingly resilient this quarter, with US banks reporting better-than-expected earnings results. Banks benefitted from robust interest income, resilient consumer spending and improving credit conditions outside of rate-sensitive sectors.

Net interest income, once a beneficiary of rising rates, continues to face headwinds due to declining net interest margins, but banks offset this in the quarter with strength in other areas, contributing to a strong top and bottom line this quarter. In a climate where earnings remain under pressure, cost discipline remains a high priority for US banks, which generally kept noninterest expenses relatively flat this quarter.

Net interest income headwinds emerge as banks consider what’s in store for Q4

Amid a rising interest rate environment, the US banking sector has exhibited divergent net interest income growth this quarter, depending on exposure to rate-sensitive markets, such as housing and automotive, with several US banks posting sequential declines in net interest margins. Housing sentiment has clearly suffered as the average 30-year mortgage approaches 8%,1 which could continue to pressure banks in the home and mortgage loan segments. Mortgage applications declined in Q32 to levels last seen in the mid-1990s when the population was 20% lower.

Deposit costs are rising faster than banks can increase rates on loans due to regulatory caps on credit cards and weakening loan demand, should banks raise rates significantly. Though banks with strong consumer loyalty fared better this quarter, overall trends point to mounting net interest income and margin challenges for the group as the Federal Reserve (the Fed) could potentially raise rates again in Q4.

Deposit runoff continues but resilient consumer lending supports loan growth

The pandemic-era surge in deposits continues to abate, with the majority of US banks with between $100 billion and $1 trillion in assets?reporting sequential declines in total deposits.3 Clients continue to shift funds to higher-yielding assets, such as money market funds. That said, resilient consumer spending — particularly credit card loans — kept loan balances growing positively despite declining deposits. Banks with a strong consumer base saw the largest loan growth this quarter, while those with a rate-sensitive mortgage and automotive lending focus faced more difficulty given persistently high rates, which weighed on originations, margins and loan demand in these areas.

Banks were able to offset the drag on net interest income by growing noninterest income in areas such as lending fees, asset management fees and card fees. And the deposit runoff managed to create an offsetting tailwind, generating increased asset management fees even as deposit balances declined. Consumer discretionary spending remained strong, credit quality remained stable, and consumer banking showed strength this quarter, particularly in digital banking and wealth management.

In the aftermath of recent bank failures, concerns around banks’ balance sheet strength and liquidity appear to have eased, as loan loss provisions decreased or generally held steady, pointing to stabilized credit conditions after the March liquidity crisis. These trends coincide with the Fed’s Bank Term Funding Program , whose loan balance has plateaued with fewer emergency financings.

Investment banking headwinds continue

For investment banking businesses, weakness continued this quarter and was exacerbated by a decline in large private equity buyouts. US M&A volumes plunged by nearly 63% in Q3 to $255.89 billion4 as the rising cost of debt forced companies to postpone their pursuit of transformative buyouts. US banks wrote down $1 billion on leveraged and bridge loans as rising interest rates made it more difficult to offload high-risk debt onto investors and other lenders. Transactions remain focused on resilient industries with high-quality assets, such as infrastructure. While there was a burst of initial public offering (IPO) activity in late summer and early fall, potential IPOs are likely to get pushed back given a volatile stock market and rising costs.?

Operating in the new normal

Looking ahead, banks must navigate an unpredictable operating environment that has become the new normal. In the September Summary of Economic Projections, Fed policymakers median rate hike expectations signaled another 25 basis point interest rate increase in Q4 given still high inflation and a strong economy and job market. Those projections indicated Fed officials projected rates remaining higher for longer in 2024. As a result, a key concern is that the Fed over-tightens monetary policy leading to a rapid tightening of financial conditions, thereby slowing the economy and risking a hard landing. An extended period of high borrowing costs could also put banks under more pressure.

Real GDP (gross domestic product) rose at a solid pace in Q3 and the labor market remains tight. That said, consumer price inflation remains elevated, and the stress on consumers and businesses is reflected in credit card delinquencies — which have reached the highest level in a decade — and annual corporate bankruptcies, which are at their highest level since 2020.5 Still, US?retail sales6?for September were stronger than expected — another sign of the economy’s unexpected resilience.

Also positive are signs that the Fed believes rates are reaching a restrictive level and that higher bond yields could substitute for further hikes. Notably, the benchmark 10-year Treasury yield surged to the highest level since before the 2008 financial crisis7. Higher bond trading was a particular strength for banks this quarter. Geopolitical tensions, such as the Israel-Hamas war, could also cap Treasury yields amid risk-off sentiment. In the near term, US banks will continue to position themselves for strong leverage to a market recovery through diversification, cost control and continued innovation.

The views reflected in this article are the views of the author and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.

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1. "Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US],” retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MORTGAGE30US , October 26, 2023.

2. “US Economy Grows Much More Than Expected,” Trading Economics website, https://tradingeconomics.com/ , accessed October 2023.

3. “Deposit runoff among large US banks persists in Q3,” S&P Global Market Intelligence website, https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/deposit-runoff-among-large-us-banks-persists-in-q3-72743236#:~:text=Deposit%20runoff%20among%20the%20largest%20U.S.%20banks%20continued,in%20assets%20reporting%20quarter-over-quarter%20declines%20in%20total%20deposits , accessed October 2023.

4. “M&A Highlights: 9M23,” Dealogic website, https://dealogic.com/insight/ma-highlights-9m23/ , accessed October 2023.

5.?“Surging U.S. Corporate Bankruptcies Already Surpass Total for All 2022,” Investopedia website, https://www.investopedia.com/surging-u-s-corporate-bankruptcies-surpass-total-for-all-2022-7569495 , accessed October 2023.

6. “Retail sales rise on strong car sales and internet buying. U.S. economy not slowing much.” MarketWatch website, https://www.marketwatch.com/story/retail-sales-rise-sharply-due-to-strong-car-sales-and-higher-gas-prices-5f9d30a9?mod=newsviewer_click , accessed October 2023.

7. “U.S. 10 Year Treasury Note,” MarketWatch website, https://www.marketwatch.com/investing/bond/TMUBMUSD10Y?countryCode=BX&mod=MW_story_quote , accessed October 2023.