Banks Brace for Rising Risks Amid Inflation and High Interest Rates

As interest rates remain at their highest levels in over 20 years and inflation continues to put pressure on consumers, major banks are gearing up to confront increased risks associated with their lending activities.

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 represent the funds set aside by financial institutions to shield against potential losses from credit risks, including overdue debts and lending troubles like those seen in commercial real estate.

JPMorgan set aside $3.05 billion for credit losses, while Bank of America allocated $1.5 billion. Citigroup’s allowance for credit losses rose to $21.8 billion at the end of the quarter, more than tripling its reserves from the previous quarter. Wells Fargo reported provisions of $1.24 billion.

These increases in provisions indicate that banks are preparing for a more challenging environment, where both secured and unsecured loans may lead to greater losses. A recent analysis by the New York Fed revealed that Americans owe a staggering $17.7 trillion in consumer loans, student loans, and mortgages.

Additionally, the issuance of credit cards and associated delinquency rates are climbing as customers deplete their savings from the pandemic and increasingly rely on credit. In the first quarter of this year, credit card balances reached $1.02 trillion, marking the second consecutive quarter that total balances exceeded the trillion-dollar threshold. The commercial real estate sector also remains vulnerable.

“The banking industry and consumer health are still emerging from the effects of COVID, significantly influenced by the stimulus provided to consumers,” stated Brian Mulberry, a client portfolio manager at Zacks Investment Management.

However, potential banking issues may arise in the future. Mark Narron, a senior director at Fitch Ratings’ Financial Institutions Group, noted that the provisions reported by banks do not necessarily reflect recent credit quality but are indicative of expected future developments.

He explained that the industry has shifted from a model where rising bad loans led to increased provisions to one where macroeconomic forecasts are driving provisioning strategies. In the near future, banks anticipate slower economic growth, rising unemployment, and two potential interest rate cuts in September and December, which could lead to increased delinquencies and defaults by the year’s end.

Citigroup’s chief financial officer Mark Mason highlighted that the emerging issues appear to primarily affect lower-income consumers, who have seen their savings diminish since the pandemic.

“While overall, the U.S. consumer exhibits resilience, there’s a notable divergence in performance and behavior among different income levels and credit profiles,” Mason noted during a recent analyst call.

He pointed out that only the highest income quartile has more savings than at the beginning of 2019, with customers maintaining high payment rates correlated with higher FICO scores. In contrast, lower FICO band customers are experiencing a decline in payment rates and are borrowing more, struggling under the weight of high inflation and interest rates.

The Federal Reserve has kept interest rates at a high range of 5.25% to 5.5% as it monitors inflation trends, aiming to stabilize them towards the central bank’s target of 2% before implementing anticipated rate cuts.

Despite banks bracing for potential defaults in the latter half of the year, current data does not indicate a burgeoning consumer crisis. Mulberry is particularly interested in the difference between pandemic homeowners and renters.

“While interest rates have climbed significantly, homeowners secured low fixed rates, mitigating their financial strain. However, renters, lacking that advantage, face greater challenges,” Mulberry stated.

With rents nationwide rising over 30% from 2019 to 2023 and grocery prices increasing by 25% during the same timeframe, renters who did not lock in low rates and are dealing with rising costs are feeling the most financial pressure.

Currently, the key takeaway from the latest earnings reports is that there are no significant new concerns regarding asset quality. Despite the challenges, banks reported solid revenues, profits, and resilient net interest income, suggesting a robust banking sector.

“There’s a strength within the banking system that is somewhat expected, but it’s reassuring to see that the financial structures remain strong and sound,” Mulberry concluded. “Nevertheless, we need to keep an eye on the situation, as prolonged high interest rates will exert more strain.”

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