Economic outlook at small banks is turning slightly sunnier

Community bankers continue to brace for a recession after 11 Federal Reserve interest rate hikes since early 2022. But coming off a decent second-quarter earnings season and seeing further signs of easing inflation pressure, more lenders — including OceanFirst Financial and First Northwest Bancorp — now anticipate only a slight economic downturn and only modest hits to credit quality.

"It's becoming more likely than it was," Christopher Maher, chairman and CEO of the $13.5 billion-asset OceanFirst, said of the odds of avoiding a bruising recession in 2023. "It's certainly not a slam dunk, but it appears more likely," he said in an interview late last week.

He and many other bankers had earlier in the year worried that surging interest rates could foster a recession. The Conference of State Bank Supervisors said its Community Bank Sentiment Index fell to a new low in the spring, spurred by worries about monetary policy and threats to profitability. Even as recently as a month ago, nearly three-quarters of 545 banks with assets under $10 billion surveyed by IntraFi said they don't think the Fed will achieve a "soft landing," where the central bank reduces inflation through interest rate hikes yet does so without causing a downturn. 

OceanFirst, based in Red Bank, New Jersey, reported slightly lower second-quarter net income when compared with a year earlier, largely due to higher deposit costs stemming from the rate hikes and increased funding competition after three regional bank failures this spring. The downfalls of Silicon Valley Bank, Signature Bank and First Republic Bank — hastened in part by deposit runs — put added upward pressure on costs and crimped banks' net interest margins. OceanFirst's NIM contracted 27 basis points from a year earlier to 3.02%.

Loan growth is contracting, too, as both consumers and commercial clients grow wary of higher interest rates. OceanFirst also is getting pickier about the loans it makes, given lingering recessionary risks. When rates rise rapidly — many consumer loan rates doubled over the past year — borrowing costs increase and bankers worry loan defaults could follow. The combination of high rates and lingering inflationary pressures historically has tilted the economy into recession. 

However, Maher said deposit competition has stabilized over the summer. And with inflation leveling off at substantially lower levels than in 2022, he and other bankers are anticipating that Fed policymakers could soon end their rate-hike campaign. The consumer price index, the federal government's key measure of cost increases across the economy, increased at a 3.2% annual rate in July.

That represented a substantial deceleration from the 40-year high of more than 9% reached in June 2022. Further evidence of progress on the inflation front would allow the Fed to cease rate increases this year, Maher said. (The Fed has a 2% targeted inflation rate.) This leaves Maher and others cautious about growth in the second half of 2023 but generally optimistic for 2024. In the meantime, bankers say credit quality remains sound, with loan losses at historically low levels.

Maher expects some festering margin pressure and lighter loan demand. But if rates stop rising, he thinks businesses across several sectors will continue to borrow and invest in a resilient economy. The U.S. economy expanded at a 2.4% annual rate in the second quarter, the Commerce Department said last week.

Matt Deines, president and CEO of the $2 billion-asset First Northwest in Port Angeles, Washington, shared a similar view.

"We see very little weakness, in terms of the economy and sentiment, when we have conversations with our clients," Deines said in an interview. "People are a bit cautious, but we don't see expectations for a dire situation or a major credit event."

To be sure, high rates and economic uncertainty continue and remain wildcards. Fed surveys of lending conditions continue to show lighter demand than a year ago and tighter lending standards as a result. Those trends in turn can drag on economic growth.

"Banks expect to tighten loan terms for the remainder of 2023 due to a deterioration in demand, which suggests that access to credit may become more challenging for businesses and individuals," Laurent Birade, a senior director at Moody's Analytics, said in an email.

Citizens Financial Group said its index of national business conditions worsened in the second quarter. It dipped to 48.5 from 53.9 the prior quarter. A reading below 50 indicates weakness.

Eric Merlis, managing director and co-head of global markets at Citizens, said in a report that, while the overall labor market remained strong in the second quarter, new business applications decreased in most states and manufacturing activity slowed.

The Citizens index results show "a business environment where activity has slowed as interest rate hikes seem to be working to curb inflation," Merlis said. "All eyes will be on the job market to see if the Fed can balance its efforts to fight inflation while minimizing impacts on employment."

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Still, Robert Bolton, president of bank investor Iron Bay Capital, said that while loan growth has slowed and deposit costs climbed, other bank fundamentals are strong. Credit quality shows no meaningful cracks and capital levels are robust on average across the industry, he said. Those readings suggest that even if an economic downturn develops, most banks will have the wherewithal to navigate it successfully, according to Bolton.

S&P Global Market Intelligence data shows that most publicly traded community banks reported second-quarter earnings per share that were lower than a year earlier, yet the vast majority of these companies remained profitable.

"I think second-quarter earnings were actually quite positive, all things considered," Bolton said in an interview. "There are headwinds, yes, but with a little more clarity on the direction of rates, banks and their customers can start getting more comfortable about future plans, and loan demand and confidence could pick up again."

Deines agreed. "I'm actually more optimistic than I was just a month ago," he said this week. "Barring some big surprise, I think that we could avoid a full recession this year … and 2024 could be pretty good for the banking industry."

OceanFirst's Maher echoed that thinking. In fact, his bank is already investing in hiring and new products to meet anticipated increases in residential-mortgage and small-business lending. High rates have dampened homebuying and business startups this year. But when rates level off, he thinks pent-up demand for both will be released.

"There could be a great deal" of loan growth ahead, Maher said.