In the latest installment of our monthly financial services update, we take a look at banking results from the fourth quarter of 2022, artificial intelligence-powered funds, and two regulatory proposals.
Q4 banking results
The bank failures of early March have changed the landscape for financial institutions since late 2022, but financial results from the end of last year still provide valuable insight into industry conditions.
Despite the widening of financial institutions’ net interest margin for the third consecutive quarter, full year 2022 net income was down compared to 2021, according to Federal Deposit Insurance Corp.’s quarterly banking profile for Q4 2022, released at the end of February. Still, last year’s full year net income was higher than the pre-pandemic average.
The moderate decline in net income last year was driven by lower noninterest income results, largely attributable to provision increases across banking organizations. Further pressure on profits is expected in 2023 as the lagged effects of the 2022 Fed rate campaign on deposit costs drive interest expense to levels not seen since the beginning of the Great Recession.
While credit quality remained strong in Q4, as supported by a flat noncurrent loans rate, the headwinds forming in the second half of 2022 began to drive up charge-off activity at the nation’s banks.
As FDIC Chair Martin Gruenberg noted in the February report, “…the banking industry continues to face significant downside risks from inflation, rising market interest rates, and geopolitical uncertainty that could hurt bank profitability, weaken credit quality and capital, and limit loan and deposit growth. These risks will be matters of continued supervisory attention by the FDIC over the coming year.”
Indeed, the confluence of macroeconomic factors that led to the Silicon Valley Bank and Signature Bank of New York collapses—a dramatically rising interest rate environment, liquidity constraints, diminished capital levels driven by bond portfolio unrealized losses, and customer concentrations—is unlikely to change despite the tremors shaking the banking landscape. (Roughly $620 billion in unrealized losses were sitting on the balance sheets of the nation’s banks at the end of 2022, according to the Federal Deposit Insurance Corp.)
The Federal Reserve also continued its rate hiking campaign in February, raising the federal funds rate 25 basis points to a target rate of 4.5% to 4.75%. February macroeconomic data shows inflation pressures persisting, and the Fed finds itself balancing whether and how much to raise interest rates in March. We believe the most likely scenario is a modest 25-basis-point increase seeking to balance the need for stability in the banking system with the fight against inflation. We expect there will then be a period of stable rates before a gradual program of rate cuts is introduced.
Exploring the performance of AI-powered funds
The rise of artificial intelligence and machine learning is transforming the asset management industry, resulting in the emergence of AI-powered funds. Not to be confused with AI heavy funds, like AIQ, that use traditional teams of researchers to inform investment in artificial intelligence, AI-powered funds leverage deep learning and natural language processing models to analyze large amounts of data and adapt to changing market conditions in real time.
Artificial intelligence exchange-traded funds currently have about $6.45 billion in assets under management, with 30 AI ETFs now in U.S. markets. Firms in the private equity industry have used AI to perform deal sourcing analysis, due diligence, portfolio management and risk management. AI-powered funds construct their portfolios in a fully automated manner by forecasting portfolio risk, researching thousands of potential companies for their portfolios and altering their portfolios around the clock, 24/7.
AIEQ, an AI-powered ETF powered by IBM Watson, gained steam earlier this year as it doubled the S&P 500’s performance. AIEQ’s owner and developer, the fintech company EquBot, says the AI-powered ETF performs the work of roughly 1,000 fund managers and analysts simultaneously. The fund applies AI technology to build predictive models on 6,000 U.S. companies using four underlying deep learning models that perform constant analysis of financial data, news data, management data, and macroeconomic data.
The use of AI in asset management and the broader financial services industry highlights an operational shift in the way investment decisions are made. AI-powered funds have the potential to outperform traditional funds, but not without risks including algorithmic bias and the need for robust risk management frameworks. Traditional funds, AI-powered, and AI heavy funds all have the potential to generate positive returns for investors, though they differ in the way they are managed, their investment processes, and their overall performance.
Overall, the adoption of AI in asset management is likely to continue and the competitive data driven landscape evolves.
Asset management and capital markets SEC update
Proposed changes to a U.S. Securities and Exchange Commission rule that applies to investment advisers would update the custodial protection standards for client assets, and affected advisers will need to reevaluate their processes and compliance programs if the changes pass.
On Feb. 15 the SEC proposed amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940. Commonly referred to as the SEC’s custody rule, Rule 206(4)-2 requires investment advisers to ensure the safekeeping of client assets that are in their possession or which they exercise authority over. The custody rule, which was initially adopted in 1962 and last amended in 2009 following cases of fraud by investment advisers that emerged during the financial crisis of 2008, is intended to protect investors’ assets from loss or misappropriation.
The proposed changes to the custody rule relate to ensuring client assets (including crypto assets) are properly segregated and held in accounts to protect the assets in the event of a qualified custodian’s bankruptcy or other insolvency. The proposal also aims to enhance protection for certain securities and physical assets that cannot be maintained by a qualified custodian—for example, artwork.
Also on Feb. 15, the SEC finalized rules to shorten the standard settlement cycle for most securities trades from the current T+2 (that is, trade date plus two business days) to T+1. The SEC set a date of May 28, 2024, for the switch to T+1. The rule is intended to benefit investors and “reduce the credit, market and liquidity risks in securities transactions faced by market participants.”
Though finalization of these new rules was widely expected, industry participants were caught off guard by the implementation deadline as they had expected a target date in the second half of 2024.
CFPB proposes to cap credit card fees
The Consumer Financial Protection Bureau is aiming to reduce credit card fees for consumers, and the impact could be significant for financial institutions.
The CFPB proposed to amend Regulation Z (this implements the Truth in Lending Act) to reduce credit card fees. If approved, the rule would: 1) lower late fees to $8 from the current amount of up to $41; 2) eliminate the automatic annual inflation adjustment for the immunity provision amount; and, 3) cap late fees at 25% of the required minimum payment vs. the current rule that allows card issuers to charge a fee that is up to 100% of the minimum payment.
Using 2020 figures, the CFPB estimates the late fees cost consumers $12 billion each year, which represents more than 10% of all credit card interest and fees charged to consumers. The proposal would cut this by $9 billion per year.
To get ahead of the change and in response to negative publicity related to the fees, several large banks began to cap their fees late in 2022. The American Bankers Association and Credit Union National Association both issued a statement noting the proposed rule could negatively impact consumers. Specifically, the proposed change would increase the cost of credit and impose higher fees for all as credit card issuers tighten their standards for new accounts, the ABA said. The CUNA said the proposal would reduce access to open-end credit.
If the proposal is approved, it would have a significant impact on revenues in an environment that is already challenging. The CFPB is seeking public comment on this proposal and the comments are due by April 3, 2023.
Gavin Murphy, a senior assurance associate with RSM US, contributed to this article.
