With interest rates at their highest levels in over 20 years and inflation affecting consumers, major banks are bracing for increased risks in their lending practices.
In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all boosted their provisions for credit losses compared to the previous quarter. These provisions are funds that banks set aside to cover possible losses from credit risks, such as delinquent debts and loans, including commercial real estate (CRE) loans.
JPMorgan allocated $3.05 billion for credit losses in the second quarter; Bank of America set aside $1.5 billion; Citigroup’s allowance reached $21.8 billion, tripling its reserves from the previous quarter; and Wells Fargo reported provisions of $1.24 billion.
These increases indicate that banks are preparing for a more challenging environment, during which both secured and unsecured loans may lead to significant losses. A recent analysis by the New York Federal Reserve revealed that American households owe a total of $17.7 trillion in consumer loans, student debt, and mortgages.
Additionally, credit card issuance is rising, along with delinquency rates, as individuals exhaust their pandemic-era savings and increasingly rely on credit. Credit card balances hit $1.02 trillion in the first quarter of this year, marking the second consecutive quarter that cardholder balances surpassed the trillion-dollar mark, according to TransUnion. The commercial real estate sector remains particularly vulnerable.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, stated, “We’re still emerging from the COVID era, particularly regarding banking and consumer health, influenced heavily by the stimulus provided.”
However, any significant challenges for banks are likely to emerge in the coming months. Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, explained that the provisions seen in any given quarter may not accurately represent credit quality but rather what banks predict will happen in the future.
He noted a shift from a historical model, where provisions increased as loans began to fail, to one driven by macroeconomic forecasts.
In the short term, banks anticipate slowing economic growth, a higher unemployment rate, and two expected interest rate cuts later in the year. This could result in increased delinquencies and defaults as the year draws to a close.
Citigroup chief financial officer Mark Mason remarked that these warning signs are particularly evident among lower-income consumers, who have experienced a decline in savings since the pandemic.
“While there is an overall resilient U.S. consumer, we see a divergence in performance across different income and credit score groups,” Mason said during a recent analyst call. He observed that only the highest-income quartile has managed to save more than at the start of 2019, with high FICO score customers driving spending growth. Lower FICO score borrowers are facing more difficulty, leading to a decline in payment rates as they struggle with high inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5%, awaiting stabilization in inflation towards its 2% target before implementing anticipated rate cuts.
Despite banks’ preparations for increased defaults later in the year, default rates have not yet surged to indicate a consumer crisis, according to Mulberry. He is closely monitoring the difference between individuals who owned homes during the pandemic and those who rented.
“Although rates have risen significantly, homeowners locked in low fixed rates on their debt, so they aren’t feeling the pressure as much,” Mulberry explained. “Renters, however, did not have that opportunity.”
With rents rising over 30% nationwide from 2019 to 2023 and grocery prices increasing by 25% during the same timeframe, renters who did not secure low rates are facing the most financial strain, as their expenses outpace wage growth.
Overall, the latest earnings reports indicate that “nothing new emerged this quarter regarding asset quality,” Narron noted. Strong revenues, profits, and solid net interest income suggest that the banking sector remains robust.
“There is some resilience in the banking sector that may not have been entirely unexpected, but it’s reassuring to see that the financial system’s structures are still strong and sound at this time,” Mulberry added. “However, we are closely monitoring the situation, as prolonged high interest rates will lead to more stress.”