With interest rates at their highest in over 20 years and inflation continuing to impact consumers, major banks are bracing for increased risks associated with 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 set aside by financial institutions to cover potential losses from credit risks, including bad debts and various types of loans, notably commercial real estate (CRE) loans.
Specifically, JPMorgan allocated $3.05 billion for credit losses during the second quarter; Bank of America set aside $1.5 billion; Citigroup’s allowance for credit losses reached $21.8 billion at the quarter’s end, more than tripling its reserves from the prior quarter; and Wells Fargo reported provisions of $1.24 billion.
These increased reserves signal that banks are preparing for a more challenging climate, with both secured and unsecured loans potentially leading to larger losses. A recent analysis by the New York Federal Reserve revealed that Americans collectively have $17.7 trillion in consumer loans, student loans, and mortgages.
Credit card issuance and delinquency rates are also rising as individuals deplete 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 in which total cardholder balances exceeded the trillion-dollar threshold, according to TransUnion. Moreover, the situation in the commercial real estate sector remains uncertain.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, observed that the banking landscape and consumer health are still feeling the effects of the COVID-19 pandemic, largely due to the stimulus measures provided during that time.
However, challenges for these banks may worsen in the coming months. Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, noted that current provisions do not solely reflect past credit quality but rather what banks anticipate for the future.
He remarked on the shift from a historical system where rising defaults lead to increased provisions, to one where macroeconomic forecasts now guide provisioning decisions.
In the short term, banks are anticipating slower economic growth, a rising unemployment rate, and two expected interest rate cuts later this year in September and December. This outlook could lead to more delinquencies and defaults as the year concludes.
Citi’s chief financial officer, Mark Mason, pointed out that emerging red flags seem to be predominantly among lower-income consumers, who have seen their savings diminish since the pandemic.
Mason explained, “While we continue to see an overall resilient U.S. consumer, we also continue to see a divergence in performance and behavior across FICO and income bands.” He added that only the highest income quartile has more savings than at the beginning of 2019, with those holding over a 740 FICO score driving spending growth and maintaining high payment rates. Conversely, lower FICO customers are experiencing significant drops in payment rates and are borrowing more due to the pressures of high inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5%, awaiting inflation metrics to stabilize toward the central bank’s 2% target before implementing anticipated rate cuts.
Despite banks preparing for a potential uptick in defaults later this year, Mulberry suggested that defaults are not currently rising at a rate indicative of a consumer crisis. He is particularly interested in the differences between homeowners and renters during the pandemic era.
He stated, “Yes, rates have gone up substantially since then, but homeowners locked in very low fixed rates, so they’re still not feeling the pain. Those who were renting during that period missed that opportunity.”
With rents increasing by more than 30% across the country between 2019 and 2023, and grocery costs rising by 25% in the same timeframe, renters who did not secure low rates are facing increased financial stress.
For the time being, it appears that there were no significant new issues in terms of asset quality in the latest earnings round. Strong revenues, profits, and resilient net interest income signal a healthy banking sector. Mulberry concluded that despite some reassuring signs, prolonged high interest rates may continue to cause stress in the financial system.