As interest rates reach their highest levels in over two decades and inflation continues to pressurize 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 all increased their provisions for credit losses compared to the previous quarter. These provisions are essentially funds set aside to cover potential losses from credit risks, which include delinquent loans and bad debts, particularly in areas like commercial real estate (CRE) loans.
JPMorgan allocated $3.05 billion in provisions for credit losses in the second quarter. Bank of America set aside $1.5 billion, Citigroup’s allowance climbed to $21.8 billion—more than tripling its reserves from the previous quarter—while Wells Fargo reported provisions of $1.24 billion.
This accumulation of reserves signals that banks are preparing for a more challenging environment, where both secured and unsecured loans could lead to greater losses. A recent report from the New York Fed indicated that total household debt has reached $17.7 trillion, encompassing consumer loans, student loans, and mortgages.
The issuance of credit cards is on the rise, as is the delinquency rate, indicating that consumers are increasingly relying on credit as their savings from the pandemic era diminish. Total credit card balances surpassed $1 trillion in the first quarter of this year, marking the second consecutive quarter where cumulative balances exceeded this threshold, according to TransUnion. Additionally, the CRE sector remains in a vulnerable state.
“The aftermath of the COVID era is still unfolding, particularly regarding banking and consumer health. Much of this is attributable to the stimulus that was provided to consumers,” stated Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, the challenges facing banks may emerge more starkly in the upcoming months. Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, emphasized that current provisions do not reflect recent credit quality but rather banks’ expectations for future developments.
He noted the shift from historical practices, where rising loan defaults led to increased provisions, to a model driven by macroeconomic forecasts.
In the short term, banks anticipate reduced economic growth, higher unemployment, and a pair of interest rate cuts expected in September and December. These factors could result in more delinquent accounts and defaults as the year concludes.
Citigroup’s CFO Mark Mason observed that signs of distress are particularly evident among lower-income consumers, who have experienced significant declines in their savings since the pandemic.
“While the overall U.S. consumer remains resilient, there is a notable variance in performance and behavior based on FICO scores and income levels,” Mason noted during a recent analyst call.
He further indicated that only the highest-income quartile maintains greater savings than prior to 2019, with those holding scores over 740 driving spending growth and keeping payment rates high. In contrast, customers with lower credit scores are facing sharper declines in payment rates and are forced to borrow more due to the pressures of rising inflation and interest rates.
The Federal Reserve has held interest rates at a 23-year high of 5.25-5.5%, as it awaits inflation metrics to stabilize closer to its target of 2% before implementing anticipated rate cuts.
Despite banks’ preparations for an uptick in defaults later this year, current rates of defaults do not yet indicate a consumer crisis, according to Mulberry. He is particularly interested in the contrast between homeowners and renters since the pandemic.
“Homeowners, who locked in low fixed rates, are not feeling the impact of rising rates to the same extent as renters, who may be struggling due to soaring rents,” he explained. Rents have surged more than 30% nationally from 2019 to 2023, while grocery prices have jumped by 25%, placing additional strain on renters’ budgets.
Nonetheless, the latest earnings reports reveal no significant deterioration in asset quality. Strong revenues, profits, and net interest income suggest that the banking sector remains robust.
“Overall, there is still strength in the banking sector, which is a relief, indicating that the financial system remains sound at this point in time,” Mulberry concluded. “However, we’re closely monitoring the situation, as sustained high interest rates will likely lead to more stress.”