S&P/ASX 200 Index (ASX: XJO) bank shares had a rough time of it last month. The decline continued into the first week of March.

In the past month, the Commonwealth Bank of Australia (ASX: CBA) share price has dropped 10%, the Westpac Banking Corp (ASX: WBC) share price has fallen 6.4%, the National Australia Bank Ltd (ASX: NAB) share price has dropped 7% and the ANZ Group Holdings Ltd (ASX: ANZ) share price declined 5.5%.

This negative return compares to a decline of just 1.7% for the S&P/ASX 200 Index (ASX: XJO) over the last month.

But, one broker thinks that banks could underperform the ASX 200 over the rest of 2023.

Negative outlook for ASX 200 bank shares

Morgan Stanley has suggested that the banking sector will underperform the ASX 200 over the rest of the year because of a combination of an economic slowdown, ongoing interest rate increases, falling house prices and higher mortgage serviceability hurdles, which could all hurt loan growth, according to reporting by The Australian.

The broker suggests that lending margins are peaking, with refinancing and discounting up, while deposit pricing benefits moderate.

Morgan Stanley’s Richard Wiles suggested that the current situation is increasing “the likelihood that major bank profit margins peak earlier and at a lower level.”

Increasing interest rates and an increasingly competitive environment are causing more volatility to bank margins. The broker suggested that margins are likely to fall in FY24.

Morgan Stanley reportedly pointed out that there don’t appear to be any near-term catalysts to accelerate loan growth. It’s also likely that loan losses are likely to worsen from here.

The broker wrote:

We forecast loss rates to rise to 16bp of loans in FY23 (estimate) and 29bp in FY24 (estimate), resulting in a double-digit earnings headwind in each year.

While FY23 could see good profit growth for the banks, the broker estimates that profit at the ASX 200 bank shares will drop by an average of 12% in FY24.

What’s going to happen with interest rates next?

Yesterday, the Reserve Bank of Australia (RBA) announced that it was increasing the cash rate target by 25 basis points to 3.60%.

The RBA noted that global inflation remains “very high” and that services price inflation “remains high”, with strong demand for some services over the summer.

Australia’s central bank noted that rents are increasing “at the fastest rate in some years”. It’s expecting inflation to decline in 2023 and 2024, reaching around 3% in mid-2025. The RBA said that medium-term inflation expectations remain “well anchored, and it is important that this remains the case.”

It was also noted that wage growth is “continuing to pick up in response to the tight labour market and higher inflation.”

In terms of the outlook, the RBA said that it “expects that further tightening of monetary policy will be needed to ensure that inflation returns to target and that this period of high inflation is only temporary.”

What does this mean for ASX 200 bank shares?

It does seem as though the share prices of the banks now reflect the tougher situation for banks.

So, I think there may not be that much more downside unless the bank’s bank losses are worse than expected in the year ahead.

I think that banks will still report higher profits and dividends in FY23. The dividends could rise in the years ahead and boost the cash returns of shareholders.

The post ASX 200 bank shares slump could continue: Morgan Stanley appeared first on The Motley Fool Australia.

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Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has recommended Westpac Banking. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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