As interest rates remain at their highest levels in over two decades and inflation continues to impact consumers, major banks are preparing to navigate increased risks associated with their lending practices.
In the second quarter, financial giants such as JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all augmented their provisions for credit losses compared to the previous quarter. These provisions represent the funds set aside by banks to shield against potential losses due to credit risk, which includes overdue payments or defaults in areas like commercial real estate loans.
JPMorgan set aside $3.05 billion for credit losses in the second quarter, while Bank of America allocated $1.5 billion. Citigroup’s allowance for credit losses reached $21.8 billion at the close of the quarter, more than tripling its previous reserve build, and Wells Fargo laid aside $1.24 billion.
This increase in reserves indicates that banks are bracing for a more challenging lending environment, wherein the risks associated with both secured and unsecured loans may lead to significant losses. A recent study by the New York Federal Reserve revealed that U.S. households owe a combined $17.7 trillion in consumer loans, student debt, and mortgages.
Credit card issuance is on the rise, and delinquency rates are also climbing as individuals deplete their pandemic-era savings and increasingly depend on credit. The total of credit card balances reached $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where it exceeded the trillion-dollar threshold, according to TransUnion. Additionally, the commercial real estate sector remains vulnerable.
According to Brian Mulberry, a client portfolio manager at Zacks Investment Management, “We’re still coming out of this COVID era,” emphasizing that much of the consumer health was previously supported by stimulus measures.
However, the anticipated challenges for banks lie ahead. Mark Narron, a senior director with Fitch Ratings, pointed out that the provisions observed in any quarter do not necessarily reflect the credit quality from the last three months, but rather the banks’ expectations for future occurrences.
He further noted, “It’s peculiar, because we have transitioned from a system where provisions would rise only when loans began to fail, to a framework where macroeconomic forecasts significantly influence provisioning.”
In the short term, banks predict a slowdown in economic growth, an uptick in unemployment, and two interest rate cuts by December. This scenario may lead to an increase in delinquencies and defaults as the year concludes.
Citi’s Chief Financial Officer Mark Mason remarked that the warning signs are particularly evident among lower-income consumers, who have seen their savings dwindle since the pandemic began.
“While we observe an overall resilient U.S. consumer, performance varies significantly by income level and credit score,” Mason stated during a recent analyst call.
He indicated that only the top income quartile has greater savings compared to 2019, and consumers with a FICO score above 740 are the ones fueling spending growth and maintaining high payment rates. Conversely, customers with lower FICO scores are exhibiting a sharper decline in payment rates and are increasingly reliant on borrowing, heavily impacted by rising inflation and interest rates.
As interest rates hold steady at a 23-year high of 5.25-5.5%, the Federal Reserve is awaiting stabilization in inflation metrics before making any anticipated cuts.
Despite preparation for a surge in defaults later in the year, analysts like Mulberry assert that defaults are not escalating at a rate indicative of a consumer crisis. He is specifically monitoring the differences between homeowners and renters since the pandemic.
While interest rates have increased considerably since then, homeowners who secured low fixed rates are not feeling the financial strain as acutely. In contrast, renters, facing significant increases in rent—over 30% nationwide from 2019 to 2023—and a 25% rise in grocery costs are facing more significant budget challenges.
For now, the latest earnings reports suggest that there are no alarming signs regarding asset quality. In fact, indicators such as robust revenues, profits, and steady net interest income point to a resilient banking sector.
“There’s some strength in the banking sector that may not have been anticipated, and it’s reassuring to confirm that the foundations of the financial system remain strong at this time,” Mulberry noted. “However, we are closely observing the situation, as prolonged high interest rates may induce additional stress.”