Banks Brace for Credit Risks Amid Economic Turbulence: What’s Next?

As interest rates remain at their highest in over two decades and inflation continues to pressure consumers, major banks are bracing for additional risks associated with their lending practices.

In the second quarter, leading financial institutions such as JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo increased their provisions for credit losses compared to the previous quarter. These provisions represent the financial resources that banks allocate to potentially cover losses arising from credit risks, such as delinquent debts and commercial real estate loans.

Specifically, JPMorgan set aside $3.05 billion for credit losses, Bank of America reserved $1.5 billion, Citigroup’s allowance climbed to $21.8 billion—more than tripling its reserves from the preceding quarter—and Wells Fargo allocated $1.24 billion.

This buildup of reserves signals that banks are preparing for a more hazardous economic environment, where both secured and unsecured loans may lead to greater losses for some of the country’s largest lenders. According to an analysis by the New York Federal Reserve, American households collectively owe $17.7 trillion across consumer loans, student loans, and mortgages.

Furthermore, credit card issuance and delinquency rates are on the rise as individuals deplete their savings accumulated during the pandemic and increasingly depend on credit. Credit card balances reached $1.02 trillion in the first quarter, marking the second consecutive quarter that total cardholder balances exceeded the trillion-dollar threshold, according to TransUnion. Commercial real estate continues to face challenges as well.

According to Brian Mulberry, a client portfolio manager at Zacks Investment Management, the banking sector’s health is still recovering from the impacts of the COVID-19 era, significantly influenced by stimulus measures provided to consumers.

Analysts suggest that any financial difficulties faced by banks may emerge in the near future. Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, emphasized that the provisions banks report reflect their future expectations rather than recent credit quality.

In the short term, banks foresee a slowdown in economic growth, rising unemployment, and potential interest rate cuts in September and December. This outlook may lead to an uptick in delinquencies and defaults as the year ends.

Citigroup’s chief financial officer Mark Mason pointed out that the concerning trends appear to be primarily among lower-income consumers, who have seen their savings diminish over the pandemic. He noted that only the highest income quartile has amassed more savings compared to early 2019, with those in higher FICO score brackets driving spending growth and maintaining payment rates. In contrast, lower FICO score customers are experiencing more significant declines in payment rates and are increasingly borrowing due to the impacts of high inflation and interest rates.

The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5% as it waits for inflation to stabilize toward its target of 2%, before proceeding with expected rate cuts.

Despite banks preparing for a possible wave of defaults later this year, current data does not indicate a significant uptrend in defaults that would signal a consumer crisis. Mulberry noted a distinction between the experiences of homeowners who secured low fixed rates during the pandemic and renters who did not. Though interest rates have surged, homeowners are largely unaffected due to their locked-in rates, while renters have faced rising costs without the same protections.

From 2019 to 2023, rents have escalated over 30%, and grocery prices have increased by 25%, placing considerable strain on renters who have seen their incomes stagnate relative to rising rental costs.

Overall, the recent earnings reports indicate no alarming shifts in asset quality for banks, with robust revenues, profits, and steady net interest income suggesting that the banking sector remains relatively healthy. Mulberry commented on the resilience of the financial system, stating that while there is strength in the sector, vigilance is necessary as long as interest rates remain elevated, which could introduce further stress.

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