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Canaries in the Coal Mine

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Oct 27, 2022

After Fed rate increases, economists predicted increased revenue for banks, but rising rates can be a slippery slope.

Canaries in the Coal Mine

As the Federal Reserve increased rates this year, prognosticators and economists predicted increased revenue for banks as existing loans were repriced and new ones were offered at higher rates. But rising rates can be a slippery slope leading to decreased revenue, and as we move into the fourth quarter, there are warning signs everywhere for lenders.

Credit risks are inherent in banking, but market risk can have a significant impact too as inflation is at a 40-year high and interest rates continue to increase.

Risk equals reserve

Last week, JPMorgan announced a 17% drop in year-over-year net income and increased its loan loss provision by $1.5 billion, while Bank of America added almost $400 million, and Zions reported a 10% increase in reserves from the prior year. These banks will not be alone in raising reserves; there will be others. Higher reserves have two immediate effects; the first is an increase in expenses on a bank's income statement, and the second reflects their loan portfolio. These reserves are essentially a self-funded insurance policy against potential loan deterioration. Factors such as interest rates, economic conditions, historical data or repayment and default all contribute to the reserve allotment.  

Outside of mortgages, no two consumer products have greater impacts on reserves and credit risk than credit cards and auto loans. Credit card balances increased to over $900 billion in the second quarter of this year, and the average credit card interest climbed to 17.96% — the highest since 1996, per

Auto loans outstanding have increased by $65 billion since Q1 2020 to $548 billion. The average monthly car payment in June was $733, while; in 2019, the average monthly payment was $554, an increase of 26%. The pandemic stimulus packages increased consumer demand, including for automobiles which helped accelerate auto loan volume along with prices for used cars. With stimulus packages a thing of the past and inflation raging, many consumers struggle to adjust. This issue is especially acute for subprime borrowers, with a 60-day delinquency rate of nearly 8.5% from the most recent reporting by Equifax. This is a big warning sign as nearly one in three American borrowers fall within a subprime category, with credit scores under 620. Overall, auto loan delinquency has also increased this year, from 1.62% in Q1 2021 to 2.18% in Q2 2022.

With total household debt surpassing $16.5 trillion in Q2 of this year, the highest level on record, banks, and credit unions have never had as much credit risk exposure as they do today.

Making a deposit but losing interest

U.S. banks have increased deposits annually since the 1940s, but that streak will likely end this year. With $19 trillion in deposits, close to 60% held by the top 24 banks, the KBW Bank Index predicts a 6% decline in deposits this year, the first in almost 80 years. 

So, why does this matter? Deposits reduction is a barometer that demonstrates a correlation of rate hike impact on the economy. Deposits stored in accounts are now being used to fund daily costs of living such as gas and groceries. The median checking account balance was $2,900 in June of this year, down from $5,300 at the height of the pandemic relief program, per The decline will have little effect on banks today as the glut in deposits has been a challenge for banks for several quarters; depressing earnings and having regulatory ramifications. But it is a harbinger of things to come. In the first half of this year, almost $550 billion of funds left money market and savings accounts, per 

As funds exit banks and flow into the economy, they often offset the cost-of-living increases and highlight the eroding purchasing power of consumers. Historically, outflows of deposits funded down payments for homes and large ticket items such as appliances, but home sales have decreased by 16% from 2021 and are projected to decrease further next year. The domino effect of these deposits funding day-to-day living expenses will permeate all areas of the economy.

In September, inflation sat at 8.2%, down from its June high of 9.1% but still at a level not seen since the 1980s. The question is, as interest rates are driven higher to temper inflation, will market risk and volatility rise as well – especially if the inflation rate remains stubbornly high?

So, what's your point?

As we navigate rate increases and high inflation, consumers will struggle to fulfill their obligations, putting pressure on banks and credit unions to generate revenue. As reserves increase, deposits decrease, and lending opportunities slow, income growth will become more challenging. Financial institutions must look from within to minimize costs and review credit criteria while running day-to-day operations — an imposing task in the best of times.

Developing organic growth strategies from within your portfolio allows you to keep pace with competitors. But a deep dive into deposit and loan performance requires a data-driven approach to achieve full earning potential and reduce performance risk. Now is the time to plan.

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