Focus on financials: Why banks and asset managers are constructive about the economy in 2024

Macro Economic Outlook

• Banks have significantly reduced the probability of a recession for the upcoming year.
• The base case expectation among financial institutions has shifted to an economic "soft landing."
• Tail risks regarding further interest rate hikes have been fundamentally reduced; a 100–200 basis point increase is now viewed as extremely unlikely.
• Forecasts anticipate a slowdown in growth and spending, with the possibility of a technical recession lasting one or two quarters.
• Unemployment and corporate default rates are projected to remain low despite the anticipated growth slowdown.
• The industry expects to remain in a "higher for longer" interest rate environment, though market sentiment is increasingly focused on potential rate cuts.

Bank Deposit and Liquidity Dynamics

• Deposit flows in the banking system have remained remarkably stable over the last three to four months.
• Banks have increased competitiveness on deposit rates, including offering "CD specials" and higher savings rates to match money market funds and treasuries.
• Operational cash used for bill payments remains within the banking ecosystem and is not migrating to higher-yielding alternatives.
• Deposit competition has subsided, partly due to a lack of significant need for incremental funding as loan demand is currently zero.
• Stability is being driven by larger banks that have largely recovered from the earlier regional banking exodus triggered by Silicon Valley Bank and First Republic failures.

Loan Demand and Underwriting

• Credit card lending is the only loan category seeing rapid growth, expanding at double-digit rates driven by consumer spending.
• Overall loan growth is stagnant or negative due to three primary factors:
  • Banks have tightened underwriting standards in anticipation of potential economic weakening over the next two to three years.
  • Banks are accumulating capital to prepare for increased regulatory requirements, leading to less competitive loan pricing.
  • Non-bank competition, specifically from the private credit sector, is displacing traditional bank lending.

Private Credit Sector Growth

• The private credit market currently manages approximately $2 trillion in Assets Under Management (AUM).
• The sector has grown at a 20% Compound Annual Growth Rate (CAGR) over the last five years.
• Analysts project 20–25% growth over the next five years, driven by institutional allocation shifts.
• Current average institutional allocations to private credit are roughly 3%, with potential to rise to 10%.
• Growth drivers include potential M&A acceleration utilizing existing "dry powder" and regulatory shifts pushing liquidity from banking to non-banking sectors.
• Private credit funds mitigate systemic risk through longer funding durations (4–6 years), lower leverage levels compared to banks, and dispersed concentration across multiple funds rather than a few large institutions.

Commercial Real Estate (CRE) Risk

• Banks have established reserves ranging from 8% to 12% against office CRE exposure, anticipating losses comparable to the 2008–2009 financial crisis.
• The primary risk concentration remains in office real estate due to oversupply, weak demand, and a 500-basis-point rise in refinancing costs.
• Banks distinguish multifamily real estate from office, citing rising rental prices, high demand for rentals due to expensive home purchases, and a lack of overbuilding.
• No significant credit quality deterioration has been observed in the multifamily sector outside of the office market.
• Banks are proactively monitoring potential contagion, though Wells Fargo and PNC indicate the dynamics in multifamily are fundamentally different from office.

Regulatory Environment (Basel III Endgame)

• The Federal Reserve's proposed Basel III Endgame framework requires the largest U.S. banks to hold 15% to 30% more capital than currently held.
• If implemented, the average U.S. bank would hold 2.5 times more capital per unit of risk than in 2007.
• Industry pushback centers on the lack of evidence that larger banks required more capital during the 2020 COVID crisis or the recent regional banking turmoil.
• Critics argue the rules could significantly increase borrowing costs for end-users, including mortgages, green energy projects, small businesses, and low-income households.
• The proposal risks reducing liquidity in the Treasury market by limiting banks' ability to provide leverage and intermediation.
• Regulators may intend to curb leverage buildup in the non-banking sector by reducing its availability from traditional banks.
• Potential liquidity voids left by banks may be filled by electronic market makers and high-frequency firms, though their reliability during extreme volatility remains uncertain.

Structural Changes in Banking

• The "regional banking crisis" highlighted that liquidity runs now occur at the speed of technology and social media amplification.
• Regulators are urged to acknowledge that uninsured depositors act as unsecured creditors during insolvency.
• Banks are expected to hold higher liquidity levels, shorten the duration of securities holdings, and diversify deposit bases to prevent sector-specific runs.

Strategic Priorities for 2024

• Large banks are prioritizing technology and competitive digital offerings over physical branches to attract customers who value convenience over price.
• The smallest banks face an existential challenge, likely necessitating M&A and consolidation to achieve the scale required to meet rising capital and liquidity standards.
• Asset managers view private credit as a permanent, long-term priority requiring the development of robust origination capabilities to fill the void left by retreating bank lending.
• Traditional asset managers are preparing to move trillions of dollars currently in money market funds (earning ~5%) into fixed income products that extend duration and take on credit risk.