As interest rates soar to levels not seen in over two decades and inflation puts pressure on consumers, major banks are bracing for increased risks tied to their lending activities.
In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all raised their provisions for credit losses compared to the previous quarter. These provisions are funds set aside by banks to cover potential losses related to bad debt and credit risks, including commercial real estate (CRE) loans.
JPMorgan allocated $3.05 billion for credit losses, while Bank of America set aside $1.5 billion. Citigroup’s allowance climbed to $21.8 billion, marking a more than tripling of its reserves from the previous quarter, and Wells Fargo’s provisions reached $1.24 billion.
This increase in reserves indicates that banks are preparing for a more uncertain economic environment where both secured and unsecured loans may lead to higher losses. Recent analysis from the New York Federal Reserve revealed that American households owe a staggering $17.7 trillion in consumer loans, student loans, and mortgages.
Credit card issuance and delinquency rates are also on the rise, as consumers begin to exhaust their savings accrued during the pandemic and increasingly depend on credit. Credit card balances surpassed $1.02 trillion for the first quarter, marking the second consecutive quarter this figure exceeded a trillion, according to TransUnion. Additionally, the commercial real estate sector remains vulnerable.
“We are still transitioning from the COVID era, and the banking sector’s health is closely tied to the stimulus provided to consumers,” noted Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, any adverse impacts on banks are expected to manifest in the upcoming months.
“The provisions reported in any quarter do not necessarily reflect credit quality from that period but rather what banks anticipate will occur in the future,” explained Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
He added, “Interestingly, we’ve shifted from a system where provisions rose as loans began to default to one where macroeconomic forecasts largely dictate provisioning.”
In the near term, banks are forecasting slower economic growth, increased unemployment rates, and potential interest rate cuts in September and December, which could result in higher delinquencies and defaults as the year ends.
Citigroup’s CFO Mark Mason highlighted that these warning signals are more pronounced among lower-income consumers, who have experienced a decline in savings since the pandemic began.
“While the overall U.S. consumer appears resilient, we see a divergence in performance across different income levels and credit scores,” Mason stated during an analyst call earlier this month. “Only the top income quartile has maintained greater savings since early 2019, and it is primarily high FICO score customers driving spending growth and consistent payment rates. In contrast, lower FICO score customers are facing a significant drop in payment rates and are borrowing more heavily due to the impacts of inflation and high interest rates.”
The Federal Reserve currently holds 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 preparing for increased defaults later this year, Mulberry asserts that default rates have not yet reached alarming levels indicative of a consumer crisis. He is particularly monitoring the contrast between homeowners and renters from the pandemic period.
“While rates have surged, homeowners have locked in low fixed rates on their mortgages, allowing them to avoid significant financial strain,” Mulberry explained. “Renters, on the other hand, missed out on this opportunity, and with rents rising over 30% from 2019 to 2023 and grocery prices increasing by 25%, those who did not secure low rates are feeling the strain on their financial well-being.”
For now, the key takeaway from the latest earnings reports is that there were no new concerns regarding asset quality. Strong revenues, profits, and net interest income suggest a banking sector that remains fundamentally healthy.
“There is strength in the banking sector, which may not have been entirely unexpected, but it is reassuring that the financial system’s structure remains robust at this time,” Mulberry said. “However, we will keep a watchful eye; prolonged high interest rates could create additional stress.”