As interest rates reach their highest levels in over two decades and inflation continues to impact consumers, major banks are bracing for increased risks stemming from 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 represent the funds banks set aside to cover potential losses from credit risks, which include delinquent or bad debts and various types of loans, such as commercial real estate (CRE) loans.
JPMorgan set aside $3.05 billion for credit losses during the second quarter, while Bank of America allocated $1.5 billion. Citigroup’s allowance for credit losses rose to $21.8 billion, more than tripling its previous quarter’s reserve, and Wells Fargo provisioned $1.24 billion.
These increased reserves indicate that banks are preparing for a more challenging lending environment, where both secured and unsecured loans could result in greater losses for these financial institutions. A recent report from the New York Fed revealed that U.S. households collectively owe $17.7 trillion, including consumer and student loans as well as mortgages.
Additionally, the issuance of credit cards and the corresponding delinquency rates have been climbing as consumers deplete their pandemic-era savings and increasingly rely on credit. According to TransUnion, credit card balances reached $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where total cardholder balances surpassed the trillion-dollar threshold. The situation for commercial real estate also remains precarious.
“We’re still emerging from the COVID period, and especially in terms of banking and consumer health, the stimulus provided has played a significant role,” noted Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, the real challenges for banks are expected to surface in the coming months. Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, explained that current provisions do not necessarily reflect credit quality from the last quarter, but rather banks’ expectations for future developments.
There is also a shift in how banks assess risk, moving from a historical model where provisions increased only when loans deteriorated to one where macroeconomic forecasts heavily influence provisioning decisions. In the short term, banks anticipate slower economic growth, a rising unemployment rate, and potential interest rate cuts later this year, which could lead to increased delinquencies and defaults.
Citi CFO Mark Mason observed that warning signs are particularly evident among lower-income consumers, who have seen their savings diminish since the pandemic. “While we see a generally resilient U.S. consumer, there is a noticeable divergence based on credit scores and income levels,” Mason stated during a recent analyst call.
Only the highest income quartile of consumer clients has maintained more savings than at the start of 2019, with those in higher credit score brackets driving spending growth and maintaining solid payment rates. In contrast, lower credit score customers are experiencing significant declines in payment rates and are borrowing more, feeling the squeeze from high inflation and interest rates.
The Federal Reserve has held interest rates steady at a 23-year peak of 5.25-5.5%, awaiting stabilization in inflation rates towards the central bank’s 2% target before considering rate cuts.
Despite banks’ preparations for potential defaults in the latter half of the year, Mulberry emphasizes that defaults have not yet increased to alarming levels indicating a consumer crisis. He is particularly interested in the dynamics between homeowners and renters during the pandemic. Homeowners, who locked in low fixed rates, are less affected by rising rates compared to renters, who have seen rents spike over 30% from 2019 to 2023 and grocery costs rise by 25%.
Currently, the key takeaway from this quarter’s earnings is that “there hasn’t been any new information regarding asset quality,” Narron pointed out. Strong revenues, profits, and robust net interest income signal a still-healthy banking sector.
“There remains a level of strength within the banking sector that may have been anticipated, but it is reassuring to note that the financial system’s structures are still sound at this moment,” Mulberry remarked. “However, we’re closely monitoring the situation, as prolonged high interest rates will inevitably introduce more stress.”