With interest rates reaching over two-decade highs and inflation continuing to pressure consumers, major banks are gearing up 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 represent the funds that banks set aside to mitigate potential losses from credit risks, including bad debt and delinquent loans, particularly in commercial real estate.
JPMorgan set aside $3.05 billion for credit losses in the second quarter, while Bank of America allocated $1.5 billion. Citigroup’s credit loss allowance rose to $21.8 billion by the quarter’s end, more than tripling its previous quarter’s credit reserve, and Wells Fargo made provisions amounting to $1.24 billion.
These provisions indicate that banks are preparing for a more challenging environment where both secured and unsecured loans may result in larger losses for some of the country’s biggest financial institutions. A recent report from the New York Fed highlights that Americans now owe approximately $17.7 trillion on various consumer loans, including student loans and mortgages.
Credit card issuance and delinquency rates are also climbing as individuals draw down their pandemic-related savings and increasingly depend on credit. Credit card balances surpassed $1 trillion for the second consecutive quarter, as reported by TransUnion. Meanwhile, the commercial real estate sector is facing significant uncertainties.
“We’re still emerging from the COVID era, and regarding banking and consumer health, the stimulus deployed to consumers played a critical role,” noted Brian Mulberry, a portfolio manager at Zacks Investment Management.
However, the real impact of potential issues for banks could unfold in the upcoming months. Mark Narron, a senior director at Fitch Ratings, explained that the provisions set aside by banks typically reflect their expectations about future credit quality rather than past performance.
He added, “It’s interesting because we’ve shifted from a system where bad loans led to increased provisions to one where economic forecasts largely drive provisioning.”
In the near future, banks anticipate a slowdown in economic growth, rising unemployment rates, and two interest rate cuts expected later this year. This scenario could lead to an increase in delinquencies and defaults by year’s end.
Citi’s CFO Mark Mason highlighted that the concerns appear to be predominantly among lower-income consumers, who have seen their savings diminish since the pandemic.
“While the U.S. consumer remains largely resilient, we observe distinct performance variances based on income and credit scores,” Mason remarked during an analyst call.
He pointed out that only the highest income quartile has more savings now than at the start of 2019, with those in the over-740 credit score segment driving spending growth and maintaining high payment rates. Conversely, consumers with lower credit scores are facing steeper declines in payment rates and are borrowing more, heavily impacted by rising inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5%, holding off on cuts until inflation stabilizes around the central bank’s 2% target.
Despite banks bracing for higher defaults in the latter half of the year, the current rates of defaults do not yet indicate a consumer crisis. Mulberry is particularly focusing on the differences between homeowners and renters during the pandemic.
“While interest rates have risen significantly, many homeowners locked in low fixed rates, so they aren’t feeling the same financial pressure,” he explained. “Renters, however, didn’t have that opportunity.”
With rents increasing by over 30% nationally from 2019 to 2023 and grocery costs rising by 25%, renters who weren’t able to secure low rates are experiencing significant budgetary strain.
Currently, the latest earnings reports suggest that overall asset quality remains stable. Strong revenues and profits, along with robust net interest income, signal a healthy banking sector.
“There’s a certain strength in the banking sector that might not have been entirely expected, but it’s reassuring to see that the financial system’s structures are still strong and sound,” Mulberry stated. “However, we continue to be vigilant, as prolonged high-interest rates will inevitably squeeze the system.”