As interest rates hover at their highest in over two decades and inflation continues to pressure consumers, major banks are preparing for potential risks associated with their lending activities.
In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all increased their provisions for credit losses compared to the previous quarter. These provisions reflect the funds that banks allocate to cover possible losses from credit risks, including delinquent loans and bad debt.
JPMorgan established a provision of $3.05 billion for credit losses in 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, which is more than triple its reserve increase from the prior quarter. Wells Fargo recorded provisions of $1.24 billion.
These increased reserves indicate that banks are preparing for a riskier economic environment, where both secured and unsecured loans may lead to significant losses for major financial institutions. According to a recent analysis of household debt by the New York Federal Reserve, Americans owe a total of $17.7 trillion in consumer loans, student loans, and mortgages.
Moreover, the issuance of credit cards and resulting delinquency rates are on the rise as consumers deplete their pandemic-era savings and increasingly rely on credit. Credit card balances reached $1.02 trillion in the first quarter of this year, marking the second quarter in a row where total cardholder balances exceeded the trillion-dollar threshold, as reported by TransUnion. Commercial real estate also remains in a vulnerable state.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, stated, “We’re still coming out of this COVID era, particularly concerning banking and consumer health, primarily due to the stimulus provided to consumers.”
Challenges for banks are anticipated in the upcoming months. Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, stated, “The provisions reported in any given quarter do not necessarily reflect credit quality for the recent months but are indicative of what banks expect going forward.”
He added that the industry has shifted from a historical model, where increasing loan defaults prompted higher provisions, to one where macroeconomic forecasts largely influence provisioning.
In the short term, banks predict slowing economic growth, rising unemployment, and potential interest rate cuts later this year, which could lead to increased delinquencies and defaults by year’s end.
Citi’s CFO Mark Mason highlighted that signs of trouble are especially prevalent among lower-income consumers, who have seen their savings decline since the pandemic. “While the overall U.S. consumer remains resilient, we observe a divergence in behavior across different income levels and credit scores,” Mason explained.
He noted that only the highest income quartile has managed to save more than at the beginning of 2019, and it is the individuals with a FICO score above 740 who are actively driving spending and maintaining high payment rates. In contrast, those in lower FICO bands are experiencing greater declines in payment rates and are borrowing more due to the impacts of high inflation and interest rates.
The Federal Reserve has sustained interest rates at a 23-year high of 5.25%-5.5% as it monitors inflation figures in hopes of achieving its 2% target before implementing much-anticipated rate cuts.
Despite banks bracing for a rise in defaults in the latter half of the year, Mulberry notes that current default rates do not indicate a consumer crisis. He is particularly observing the distinction between homeowners during the pandemic and renters.
Mulberry remarked, “Yes, rates have increased significantly, but homeowners locked in low fixed rates on their debt and are therefore less impacted. Renters, however, have faced substantial rental increases without similar opportunities.”
With rental prices surging over 30% nationwide between 2019 and 2023 and grocery costs rising 25% during the same period, renters not benefiting from low rates are under more pressure on their monthly budgets.
Overall, the latest earnings results suggest that “there was nothing new this quarter regarding asset quality,” according to Narron. Strong revenues, profits, and resilient net interest income point to a healthy banking sector overall.
“There’s some strength in the banking sector that was not entirely unexpected, but it’s reassuring to see that the financial system remains robust,” Mulberry concluded. “However, we are keeping a close watch; prolonged high interest rates will inevitably create more stress.”