Loan loss reserves are once again becoming a major focus for credit card issuers as banks prepare for rising interest rates, persistent inflation, and growing economic uncertainty. Early second-quarter earnings results from major institutions including Chase, Citi, and Wells Fargo show banks strengthening their balance sheets and increasing reserves in anticipation of potential credit deterioration heading into 2023. While consumer spending remains relatively stable, financial institutions are taking a more cautious approach as recession concerns continue to build.
As credit card issuers prepare for the perfect storm of rising interest rates and surging inflation, initial bank results indicate that top issuing credit card firms will be ready for potential risk as they move towards 2023. With Chase, Citi, and Wells reporting, it is evident that top credit card issuers are preparing their balance sheets with solid loan loss reserves.
Remember CECL?
Following the Great Recession, banks were required to change their loan loss reserves to a more conservative model. The Allowance for Loan Loss requirement, which keeps banks steady as charge-offs rise, drove down profits in late 2019. As painful as it was, it forced credit card issuers to be over-reserved as COVID-19 took hold. You can read about the accounting nuances in this Mercator Advisory Classic or know that these reserves came in handy when credit card issuers needed to smooth revenue lost from decreased purchasing activity during COVID.
Driving CECL was Dodd-Frank
Banks were given a battery of tests to ensure they had sufficient capital to face an economic crisis. These tests became an annual requirement to ensure that capital adequacy would be enough in the event of credit quality erosion, surging unemployment, or deflating security behind loan assets. 2022 results indicated that all significantly important financial institutions would pass muster. The current Federal Reserve results are available here.
What’s Happening Now with 2Q Results
Top banks report a dip in earnings, but in most cases, it is to build their loan loss reserves. Chase announced that “earnings fell short of analyst expectations as the banks funded reserves for bad loans by $428 million,” according to CNBC. Jamie Dimon warned that “geopolitical tension, high inflation and waning consumer confidence could hurt the economy ‘somewhere down the road.’”
Citi, which beat revenue expectations, reported a net revenue decline. Still, CEO Jane Fraser noted: “In a challenging macro and geopolitical environment, our team delivered solid results and we are in a strong position to weather uncertain times, given our liquidity, credit quality and reserve levels.”
And Wells CEO Charlie Scharf indicated “credit losses to increase from these incredibly low levels” in the future.
The Takeaway
There is no question that an economic storm is brewing. This is not screaming “fire” in a movie theatre. A recession looms, inflation is sky-high, and the way to control it is by driving up interest rates. It is time for credit card issuers to prepare for the storm, and as you will read in this recently published Mercator Report, is to Drive Down Costs before Loan Losses Rise. The banking system is bracing for shock and that with tight controls, it will weather the storm.
Overview by Brian Riley, Director, Credit Advisory Service at Mercator Advisory Group
