As interest rates remain at their highest levels in over two decades and inflation continues to impact consumers, major banks are preparing for increased risks associated with their lending practices.
In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all reported an increase in their provisions for credit losses compared to the previous quarter. These provisions represent the funds set aside by financial institutions to cover potential losses due to credit risk, including bad debts and issues related to lending, especially in commercial real estate.
Specifically, JPMorgan allocated $3.05 billion for credit losses during the second quarter, while Bank of America set aside $1.5 billion. Citigroup’s allowance for credit losses reached $21.8 billion at the end of the quarter, reflecting a substantial increase from the prior quarter. Wells Fargo reported provisions of $1.24 billion.
These provisions indicate that banks are preparing for a more challenging environment, where both secured and unsecured loans could result in greater losses for some of the largest banks in the nation. A recent report from the New York Federal Reserve revealed that American households collectively owe $17.7 trillion in consumer loans, student loans, and mortgages.
Increasing credit card issuance and delinquency rates are also evident as consumers exhaust their savings accumulated during the pandemic and increasingly rely on credit. Total credit card balances reached $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where cardholder balances exceeded the trillion-dollar threshold, according to TransUnion. Additionally, the commercial real estate sector remains vulnerable.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, commented on the ongoing effects of the COVID era, particularly regarding banking and consumer health, which were heavily influenced by stimulus measures directed at consumers.
Looking ahead, potential issues for the banks are expected to emerge in the coming months. Mark Narron, a senior director with Fitch Ratings’ Financial Institutions Group, explained that the provisions reported in any given quarter do not necessarily correlate with the quality of credit for that specific timeframe; instead, they reflect banks’ expectations for future conditions.
He noted a significant shift from a traditional system where provisions increased in response to deteriorating loan quality to a system increasingly driven by macroeconomic forecasts.
In the short term, banks foresee a slowdown in economic growth, rising unemployment rates, and two anticipated interest rate cuts later this year in September and December, which could lead to increased delinquencies and defaults as the year concludes.
Citi’s chief financial officer, Mark Mason, pointed out that these warning signals particularly affect lower-income consumers, who have seen their savings diminish since the pandemic began. He mentioned that while the overall U.S. consumer remains resilient, there is a notable divergence in behavior and performance across different income levels and credit scores.
Currently, only the highest income quartile has more savings compared to the beginning of 2019, with customers boasting FICO scores over 740 driving spending growth and maintaining high payment rates. Conversely, customers with lower FICO scores are experiencing a decline in payment rates and increasing borrowing due to the impacts of high inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high between 5.25% and 5.5%, awaiting stabilization of inflation towards its 2% target before proceeding with the anticipated rate cuts.
Despite banks bracing for wider defaults later in the year, Mulberry asserted that defaults have not yet risen dramatically enough to indicate a consumer crisis. He highlighted the distinction between homeowners and renters during the pandemic. Homeowners who secured low fixed rates on their mortgages are largely insulated from the financial strain felt by renters, who have faced a more than 30% increase in rents nationwide from 2019 to 2023 and rising grocery costs of 25% during the same period.
For now, the most significant takeaway from recent earnings reports is that there have been no alarming developments in asset quality. Strong revenues, profits, and resilient net interest income suggest that the banking sector remains stable and healthy.
Mulberry observed that while the current state of the banking sector is reassuring, ongoing elevated interest rates are a cause for concern, as prolonged high rates could induce more financial stress.