By Noor Zainab Hussain, Manya Saini and Saeed Azhar

(Reuters) -Wells Fargo & Co’s profit surpassed expectations for the first quarter on Friday as it earned more from higher interest rates, even while executives forecast tighter monetary policy would dampen economic activity.

The bank also reported a $643 million increase in the allowance for credit losses, including for loans on commercial real estate, credit cards and cars.

Analysts have warned of further weakness in the commercial real estate (CRE) market as widespread remote working emptied offices in major cities. Wells Fargo executives detailed the bank’s exposure to CRE at length during a conference call with analysts. 

“There are pockets of risks such as commercial office real estate, which will likely impact institutions differently,” said CEO Charlie Scharf. “We’re proactively managing our own exposures.”

The company’s outstanding CRE loans stood at $154.7 billion, or 16% of total loans, with $35.7 billion in office loans at the end of March.

The office market continues to show signs of weakness due to lower demand, higher financing costs and challenging capital market conditions, Chief Financial Officer Mike Santomassimo said.

While meaningful losses have not ye materialized, “we expect to see more stress over time,” he said.

The bank’s shares edged 0.4% higher on Friday afternoon. They had risen more than 4% in premarket trading after the results beat expectations.

ECONOMIC OUTLOOK

While rate hikes have helped shore up interest income at U.S. lenders in recent quarters, the gains have come with increasing worries about the economy as the Federal Reserve keeps rates “higher for longer.”

“Given the rate of rate increases, we do expect some slowing in the economy – but so far its been very strong. You can also see that in the labor market,” Santomassimo said.

The bank set aside $1.21 billion in the quarter to cover for potential loan losses, compared to a release of $787 million a year earlier.

Banks are building up rainy day funds as fears of an economic slowdown mount from the Fed’s aggressive interest rate hikes, as well as the recent turmoil in the banking sector fueled by the failures of two mid-sized banks. 

The collapse of Silicon Valley Bank and Signature Bank last month prompted a rout in bank stocks as investors fretted over broader weaknesses in the industry.

Wells Fargo contributed $5 billion as part of a group of large U.S. banks that injected a combined $30 billion in deposits into First Republic Bank in March.

“We are glad to have been in a strong position to help support the U.S. financial system during the recent events that impacted the banking industry. Regional and community banks are an important part of our financial system,” Scharf said in a statement.

Deposits at Wells Fargo fell 2% to $1.36 trillion at the end of March, compared with $1.38 trillion at the end of last year.

RATES BOOST

Net-interest income surged 45% from the same quarter a year ago, to $13.34 billion.

The bank earned $1.23 per share, excluding one-time items, for the quarter ended March 31. That compared with analysts’ average estimate of $1.13 per share, according to Refinitiv IBES data.

Higher interest rates also bolstered JPMorgan Chase & Co’s profit in the first quarter and the biggest U.S. lender remained resilient through the banking crisis.

“Both Wells Fargo and JP Morgan delivered very, very solid results, blowing past the expected earnings. Deposits were down, but really these big banks have been so awash in deposits for the past few years that they have not known how to put the money to work,” said Opimas CEO Octavio Marenzi.

“The only part of the businesses that looked weak was investment banking,” he added.

Average loans in the bank’s commercial banking division rose 15%, while commercial loans rose roughly 7% from a year earlier.

Wells Fargo is also still working to contain the fallout from a scandal over its sales practices that led to hefty fines and an asset cap imposed by the Fed.

Overall, non-interest expenses fell to $13.68 billion from $13.85 billion a year earlier, mainly driven by lower operating losses.

In the fourth quarter of 2022, the bank had posted $3.3 billion in operating losses related to lawsuits, customer remediation and regulatory matters linked to the scandal.

In 2020, Scharf said he was looking to cut $10 billion of costs over several years.

Wells Fargo’s total revenue rose 17% to $20.73 billion in the first quarter.

(Reporting by Noor Zainab Hussain and Manya Saini in Bengaluru and Saeed Azhar in New York; additional reporting by Bansari Mayur Kamdar; Editing by Sriraj Kalluvila and Chris Reese)

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