As interest rates reach their highest level in over two decades and inflation continues to affect consumers, major banks are preparing for greater risks linked to their lending activities.
In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all increased their reserves for credit losses compared to the previous quarter. These reserves are the funds that banks allocate to cover potential losses from credit risks, including defaults and bad debt, 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 end of the quarter, more than tripling its credit reserve from the prior quarter, and Wells Fargo set aside $1.24 billion.
These increased reserves indicate that banks are preparing for a riskier lending environment, where both secured and unsecured loans may lead to larger losses. A recent report from the New York Federal Reserve revealed that Americans currently hold a total of $17.7 trillion in consumer loans, student loans, and mortgages.
The number of credit cards issued, as well as delinquency rates, has also increased, as consumers deplete their pandemic savings and turn to credit for assistance. In the first quarter, credit card balances reached $1.02 trillion, marking the second consecutive quarter in which total cardholder balances exceeded the trillion-dollar threshold, according to TransUnion. Furthermore, the commercial real estate sector remains vulnerable.
“We’re still recovering from the COVID period, particularly regarding the banking sector and consumer health, which was heavily influenced by stimulus measures provided to consumers,” noted Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, challenges for banks are expected to arise in the upcoming months. According to Mark Narron of Fitch Ratings, the provisions reported by banks in any given quarter may not accurately reflect the credit quality experienced in the immediate past but rather the expectations for the future.
“It’s interesting to see the shift from a historical approach, where increasing loan defaults would lead to higher provisions, to a system where macroeconomic forecasts largely influence provisioning,” Narron explained.
In the short term, banks are bracing for slower economic growth, a potential rise in unemployment, and anticipated interest rate cuts later this year in September and December. This could lead to an increase in delinquencies and defaults as the year progresses.
Citi’s Chief Financial Officer Mark Mason highlighted that current warning signs are prevalent among lower-income consumers, who have seen their savings diminish over the years since the pandemic began.
“While the general U.S. consumer remains resilient, we observe different performance trends across income and FICO score categories,” Mason stated during a recent analyst call. He pointed out that only consumers in the highest income bracket have maintained more savings than they had in early 2019, and it is primarily those with FICO scores above 740 who contribute to spending growth and high payment rates. In contrast, lower FICO score consumers are facing sharper declines in payment rates and are borrowing more, as they are significantly affected by elevated inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high between 5.25% and 5.5%, waiting for inflation measures to stabilize around its 2% target before considering any potential rate cuts.
Even though banks are gearing up for a rise in defaults during the latter half of the year, Mulberry states that current default rates do not indicate an impending consumer crisis. He is particularly observing the distinction between homeowners and renters during the pandemic.
“While interest rates have risen considerably since then, homeowners managed to secure very low fixed rates on their debt, thus not experiencing as much financial strain,” Mulberry added. “Renters, however, did not have the same opportunity.”
With rents increasing by more than 30% nationwide and grocery prices climbing 25% from 2019 to 2023, renters who could not benefit from low fixed rates are facing significant financial pressure due to rising rental costs that outpace wage growth.
For now, the primary takeaway from this earnings period is that “the quarter revealed nothing new regarding asset quality,” Narron remarked. Despite the challenges, strong revenues, profits, and stable net interest income suggest a resilient banking sector.
“There’s a degree of strength in the banking sector that may not have been entirely anticipated, but it’s reassuring that the structures of the financial system remain robust,” Mulberry concluded. “However, the longer high interest rates persist, the more strain they will impose.”