Banks Brace for Borrower Struggles as Interest Rates Soar

As interest rates remain at their highest levels in over two decades and inflation continues to pressure consumers, major banks are preparing for increased risks linked to their lending practices.

In the second quarter of the year, major banks including JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo increased their provisions for credit losses compared to the previous quarter. These provisions are funds set aside by financial institutions to mitigate potential losses from credit risks, which encompass delinquent or defaulted debts, as well as various types of loans, particularly in commercial real estate.

Specifically, JPMorgan allocated $3.05 billion for credit loss provisions during the second quarter, while Bank of America set aside $1.5 billion. Citigroup’s allowance for credit losses reached $21.8 billion by the end of the quarter, marking over a threefold increase from the previous quarter, and Wells Fargo’s provisions amounted to $1.24 billion.

This increase in reserves indicates banks are preparing for a more challenging lending environment, where both secured and unsecured loans may result in higher losses. A recent report from the New York Federal Reserve estimated that American households owe a staggering $17.7 trillion across various types of loans, including consumer loans and mortgages.

Moreover, credit card issuance and delinquency rates are climbing as consumers deplete their savings accumulated during the pandemic and turn increasingly to credit. As of the first quarter of this year, total credit card balances exceeded $1 trillion for the second successive quarter, according to TransUnion. At the same time, the commercial real estate sector faces ongoing challenges.

Brian Mulberry, a client portfolio manager at Zacks Investment Management, mentioned that the banking sector’s and consumers’ financial health are still recovering from the pandemic, largely due to governmental stimulus measures.

Challenges for banks, however, are expected to surface in the coming months. Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, emphasized that current provisions don’t necessarily reflect recent credit quality but rather banks’ forecasts for the future.

He noted a shift in how provisions are determined, moving from a reactive to a more predictive model influenced by macroeconomic conditions. With expectations of slowing economic growth, rising unemployment rates, and potential interest rate cuts later this year, banks may be preparing for an increase in delinquencies and defaults.

Citigroup’s Chief Financial Officer, Mark Mason, highlighted that red flags are particularly evident among lower-income consumers who have depleted their savings since the pandemic started.

“While we continue to see an overall resilient U.S. consumer, we also continue to see a divergence in performance and behavior across income levels,” Mason explained. He pointed out that only the highest income quartile has more savings compared to early 2019, with higher credit scores (above 740) driving spending growth and maintaining payment rates. In contrast, lower credit score individuals are facing greater challenges due to high inflation and interest rates.

The Federal Reserve has kept interest rates at a 23-year high of 5.25% to 5.5%, holding off on rate cuts until inflation stabilizes toward its 2% target.

Despite the banks bracing for potential higher defaults in the latter half of the year, Mulberry noted that defaults have not yet escalated to levels indicating a consumer crisis. He is closely monitoring the differences between homeowners and renters from the pandemic period. He pointed out that while rates have increased substantially, homeowners benefitted from locking in low fixed rates, mitigating their financial distress.

In contrast, renters have experienced a 30% increase in rent from 2019 to 2023 and rising grocery costs, leading to significant stress on their budgets, particularly as wage growth has not kept pace.

At this point, analysts noted that recent earnings reports did not reveal any new issues regarding asset quality. Positive indicators such as strong revenues, profits, and solid net interest income reflect a resilient banking sector.

Overall, the report suggests robust elements within the banking system, providing some reassurance amid concerns regarding long-term high-interest rates and their potential impact on financial stability.

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