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As credit conditions deteriorate in 2023, operating performance in the U.S. banking sector is expected to erode, says Fitch Ratings.

In a new report, the rating agency said its base case for the U.S. economy next year is for a mild recession, which will drive loan loss provisions higher in the banking sector and weigh on earnings, asset quality, funding and liquidity.

“Importantly, the expectation for rising credit losses next year is coming off of historically low levels in 2022,” it said.

Additionally, the banks’ capital levels and liquidity buffers are also quite strong, particularly compared to their levels before the financial crisis, the report noted.

Most U.S. banks have a stable rating outlook heading into 2023, it noted.

“Despite the expectation for a deteriorating sector outlook, Fitch does not envision broad-based negative rating activity for U.S. banks, as most U.S. banks have rating headroom to absorb some modest deterioration in credit fundamentals,” it said.

Nevertheless, the impact of higher rates on inflation and employment will be “key items to watch in 2023” — along with the effect on credit losses, loan underwriting standards and net interest margins.

Heightened market volatility could also boost banks’ trading revenue, while posing a threat of greater-than-expected financial asset deflation, Fitch said.