Banks Brace for Impact: Are Higher Interest Rates Really Hurting Consumers?

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

In their second-quarter reports, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all increased their provisions for credit losses compared to the previous quarter. These provisions act as reserves set aside to cover possible losses stemming from credit risks, including unpaid debts and lending activities related to commercial real estate.

JPMorgan allocated $3.05 billion to its credit loss reserves, 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—tripling its reserves from the previous quarter—and Wells Fargo reported provisions of $1.24 billion.

These increases signal that banks are preparing for a challenging environment, where both secured and unsecured loans may lead to greater losses for some of the largest financial institutions. A recent analysis from the New York Fed revealed that American households collectively carry $17.7 trillion in consumer loans, student loans, and mortgages.

There’s also a noticeable rise in credit card issuance and delinquency rates as individuals deplete their pandemic-era savings and rely more heavily on credit. Credit card balances soared to $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where total cardholder balances surpassed the trillion-dollar mark, according to TransUnion. The commercial real estate sector also remains vulnerable.

As Brian Mulberry, a client portfolio manager at Zacks Investment Management, noted, the current banking situation and consumer health are heavily influenced by the stimulus measures provided during the pandemic.

Challenges for banks are anticipated in the upcoming months. Mark Narron, a senior director at Fitch Ratings, explained that the provisions reflected in any quarter do not directly correlate to the credit quality observed in the prior months; instead, they indicate banks’ expectations for future developments.

Narron highlighted a shift in the system, where macroeconomic forecasts now play a significant role in determining provisioning, moving away from the past system where rising loan defaults would trigger an increase in provisions.

Looking ahead, banks are forecasting a slowdown in economic growth, rising unemployment rates, and expected interest rate cuts in September and December. This could potentially lead to an uptick in delinquencies and defaults as the year comes to an end.

Citi’s chief financial officer, Mark Mason, pointed out that these warning signs are primarily evident among lower-income consumers, whose savings have decreased since the pandemic.

“While we still see a generally resilient U.S. consumer, there’s a clear divergence in performance and behavior across different income and credit score levels,” Mason stated during a recent analyst call. He emphasized that only the highest income quartile has more savings than before 2019, with consumers boasting a FICO score above 740 driving spending growth and maintaining high payment rates. Conversely, those in lower FICO brackets are witnessing significant declines in payment rates and are borrowing more due to the effects of high inflation and interest rates.

The Federal Reserve has kept interest rates stable at a historic high of 5.25-5.5% as it awaits stabilization in inflation metrics towards its 2% target before considering the long-anticipated rate cuts.

Despite preparations for increased defaults in the latter half of the year, Mulberry noted that current default rates do not yet indicate a consumer crisis. He is particularly monitoring the divide between homeowners and renters during the pandemic.

Although interest rates have risen substantially, homeowners who secured low fixed-rate loans are largely insulated from immediate financial distress, whereas renters who did not benefit from low rates are facing significant challenges due to increasing rental costs and rising grocery prices.

Currently, the most significant takeaway from the latest earnings reports is that there have been no notable shifts in asset quality. Robust revenues, profits, and stable net interest income demonstrate that the banking sector remains healthy.

Mulberry concluded that while there’s ongoing strength in the banking sector, sustained high interest rates could exacerbate stress over time.

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