Banks Brace for Economic Storm: Are Credit Risks on the Rise?

As interest rates remain at their highest levels in over two decades and inflation continues to impact consumers, major banks are preparing for increased risks associated with their lending practices.

In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all increased their provisions for credit losses compared to the previous quarter. These provisions are funds set aside by financial institutions to cover potential losses stemming from credit risks, including delinquency and bad debt related to loans, particularly in commercial real estate (CRE).

JPMorgan allocated $3.05 billion for credit losses, while Bank of America set aside $1.5 billion. Citigroup’s allowance for credit losses reached $21.8 billion by the end of the quarter, more than tripling its reserve build from the previous quarter. Wells Fargo also increased its provisions to $1.24 billion.

These increased reserves indicate that banks are bracing for a riskier economic landscape, where both secured and unsecured loans might lead to substantial losses. According to the New York Federal Reserve, total household debt has surged to $17.7 trillion, encompassing consumer loans, student loans, and mortgages.

Moreover, the rate of credit card issuance and delinquency is climbing as consumers deplete their savings from the pandemic and rely more on credit. Credit card balances hit $1.02 trillion in the first quarter, marking the second consecutive quarter that balances surpassed the trillion-dollar mark, as reported by TransUnion. The state of CRE also remains troubling.

According to Brian Mulberry, a client portfolio manager at Zacks Investment Management, the banking environment’s challenges are emerging as the nation continues to recover from the COVID-19 pandemic, particularly concerning consumer health impacted by government stimulus measures.

Experts suggest that the provisions set aside by banks reflect future expectations rather than current credit quality. Mark Narron of Fitch Ratings explains that the provisioning practices have shifted from being reactive to bad loans towards being based on macroeconomic forecasts.

In the short term, banks expect slower economic growth, increased unemployment, and potential interest rate cuts later this year, which could lead to more delinquencies and defaults.

Mark Mason, chief financial officer of Citigroup, emphasized that the economic strains are primarily affecting lower-income consumers who have seen their savings diminish significantly since the pandemic. He observed that only the highest income group has managed to increase their savings compared to early 2019.

The Federal Reserve has maintained interest rates between 5.25% and 5.5% and is waiting for inflation to stabilize around the target of 2% before making any cuts.

Despite the banks’ preparations for a potential rise in defaults, current default rates are not indicative of an impending consumer crisis, according to Mulberry. He notes the contrast between homeowners, who secured low fixed-rate mortgages during the pandemic, and renters, who face rising costs and budget constraints due to escalating rents and grocery prices.

Ultimately, the latest earnings reports reveal no alarming changes in asset quality. Instead, robust revenues and profits alongside stable net interest income suggest that the banking sector remains in good health. Mulberry pointed out that while the banking system appears strong, extended periods of high-interest rates could inevitably lead to increased stress in the sector.

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