So far, the slowing economy has been good news for bankers who saw potential interest rate increases as a major threat to their stock valuations. But as the Federal Reserve's series of interest rate hikes begins to slow the economy, concerns about asset quality are moving to center stage.
"A sluggish economy" not only would diminish loan demand, analyst David Stumpf of A.G. Edwards wrote in a comment on the banking industry last Thursday, but also "could put additional pressure on credit quality."
Mr. Stumpf wrote that he does not expect a commercial credit meltdown but concluded that a "modest commercial credit cycle could have downward pressure on bank earnings estimates over the next quarters."
He said he worries that banks have become less careful about loan pricing and underwriting during the long economic expansion. Some sectors of the economy - notably retail - have not grown as fast as technology and now face problems that could hurt banks' lending portfolios, he said. Tightening loan terms in anticipation of a slower economy would only make it more difficult for such borrowers to repay, Mr. Stumpf said.
Susan L. Roth, an analyst at Donaldson, Lufkin & Jenrette Securities Inc., wrote on Aug. 15 that nonperforming commercial assets and commercial loan losses are rising and even consumer loans show signs of deterioration.
"Evidence of credit-quality erosion is manifesting itself more broadly this year, with weakness spread across a variety of industries (entertainment, textiles, health-care)," she wrote.
"Investors should always be concerned about asset quality," said Richard Bookbinder, managing member of Bookbinder Capital LLC. He said he is concerned about rising default rates but said the banks' efforts in recent years to diversify their balance sheets would "smooth out earnings."
Banks have reacted to potential credit problems by tightening standards for commercial and industrial loans, according to a survey published by the Federal Reserve System in August.
Rising energy costs will translate into higher prices in all sectors, analysts say, and not only cut earnings at airlines and automakers but also, potentially, cut into consumer spending this winter. Slower sales would threaten retailers' lenders with defaults.
Americans took on less consumer debt in July than in June, a sign that household spending is already on the decline.
The Federal Reserve said Friday that consumer credit expanded a seasonally adjusted $9.4 billion in July, rising at a 7.7% annual rate, the smallest increase since April.
But Mike Seiler, portfolio manager of Aldie-Partners, the hedge fund of Capital Resources, said that credit quality is mostly a psychological problem. "We haven't seen serious problems, and nonperforming assets are still low," he said. "I don't doubt that these problems are there, but banks are much better prepared than 10 years ago."
Mr. Stumpf agreed that risk management has become more sophisticated but argued that slower loan growth, as well as the fading option of using loan-loss reserves to boost earnings, will hurt results in coming quarters.
In trading Friday, the American Banker index of 225 banks gained 1.8%, and its index of the top 50 banks gained 2.1%.