As interest rates reach their highest levels in over 20 years and inflation continues to pressure consumers, major banks are preparing for potential challenges related to their lending practices.
In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo increased their provisions for credit losses compared to the previous quarter. These provisions represent the funds that banks set aside to account for potential losses from credit risks, which include past-due debts and lending, such as commercial real estate (CRE) loans.
JPMorgan allocated $3.05 billion to provisions for credit losses; Bank of America set aside $1.5 billion; Citigroup’s allowance for credit losses reached $21.8 billion, more than tripling its reserves from the previous quarter; and Wells Fargo had provisions totalling $1.24 billion.
These heightened provisions indicate that banks are bracing for a more challenging environment, where both secured and unsecured loans may result in greater losses. A recent survey by the New York Federal Reserve found that U.S. households carry a staggering $17.7 trillion in consumer debt, including loans for auto purchases, student loans, and mortgages.
In addition, credit card issuance and delinquency rates are climbing as consumers exhaust their savings from the pandemic and increasingly turn to credit. In the first quarter of this year, credit card balances surpassed $1.02 trillion for the second consecutive quarter, according to TransUnion. The commercial real estate sector also remains at risk.
“We’re still emerging from the COVID era, particularly concerning banking and consumer health, which was heavily influenced by the stimulus measures provided to consumers,” commented Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, any significant repercussions for banks are expected in the coming months.
“The provisions you see for any given quarter do not necessarily reflect credit quality for those three months; they are based on banks’ expectations for the future,” said Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
“We’ve shifted from a system where rising bad loans increased provisions to one where macroeconomic forecasts largely dictate provisioning,” he added.
Looking ahead, banks are forecasting slower economic growth, higher unemployment rates, and potential interest rate cuts later this year in September and December, suggesting an increase in delinquencies and defaults toward the end of the year.
Mark Mason, chief financial officer of Citi, indicated that the emerging challenges predominantly affect lower-income consumers, who have seen their savings diminish since the pandemic.
“While the overall U.S. consumer remains resilient, we observe a divergence in performance and behavior across different income and credit score categories,” Mason noted during a recent analyst call.
“Only the highest income quartile has more savings now compared to early 2019, and customers with FICO scores over 740 are driving spending growth and maintaining high payment rates,” he explained. “In contrast, lower FICO score customers are experiencing sharp declines in payment rates and are borrowing more due to heightened inflation and interest rates.”
The Federal Reserve has kept interest rates at a two-decade high of 5.25-5.5%, awaiting stabilization in inflation measures to meet its 2% target before implementing expected rate cuts.
Despite banks preparing for a potential increase in defaults later this year, Mulberry stated that current default rates do not yet signal a consumer crisis. He noted observing the disparity between homeowners and renters during the pandemic.
“Yes, rates have surged significantly since then, but homeowners locked in very low fixed rates on their debt, so they are largely insulated from the financial strain,” Mulberry remarked. “In contrast, renters who did not secure those low rates are facing significant challenges.”
With rents having increased over 30% nationally from 2019 to 2023 and grocery costs rising by 25% in the same timeframe, renters—many of whom lack the financial buffer of low-rate mortgages—are under considerable strain in their monthly budgets.
For now, the key takeaway from the latest earnings reports is that “this quarter brought no new developments regarding asset quality,” Narron stated. Strong revenues, profitability, and resilient net interest income reflect a robust banking sector.
“There is some strength in the banking sector, which wasn’t entirely unexpected, but it’s certainly reassuring to see the financial system’s structures remain strong and sound at this time,” Mulberry added. “However, we must keep a close watch, as prolonged high interest rates will lead to increased stress.”