Amidst interest rates reaching their highest levels in over 20 years and ongoing inflation pressures, 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 reported an increase in their provisions for credit losses compared to the previous quarter. These provisions are funds set aside by financial institutions to cover potential losses stemming from credit risk, including issues with delinquent debts and 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 credit loss allowance rose to $21.8 billion, more than tripling their reserves from the previous quarter, and Wells Fargo recorded provisions of $1.24 billion.
The accumulation of reserves suggests that banks are preparing for a riskier economic environment, where both secured and unsecured loans could lead to significant losses. A recent study by the New York Fed highlighted that Americans collectively owe $17.7 trillion in consumer loans, student loans, and mortgages.
Meanwhile, credit card issuance and delinquency rates are climbing as households exhaust their pandemic savings and increasingly rely on credit. Credit card balances surpassed $1.02 trillion in the first quarter—marking the second consecutive quarter in which balances crossed this threshold, according to TransUnion. The commercial real estate sector also remains in a vulnerable state.
“We’re still emerging from the COVID era, particularly regarding banking and consumer health, which was largely bolstered by stimulus payments,” stated Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, banks may face challenges in the coming months. “The provisions you see at any given quarter do not necessarily indicate the credit quality of the last three months; rather, they reflect what banks anticipate for the future,” explained Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
“You see an interesting shift; we have transitioned from a system where bad loans increased provisions to one where macroeconomic forecasts heavily influence provisioning,” he added.
Short-term forecasts for banks indicate a slowdown in economic growth, a rise in unemployment, and expectations for two interest rate cuts later this year. These factors could lead to more delinquency and defaults as the year concludes.
Citi’s chief financial officer Mark Mason shared that concerns appear to be focused on lower-income consumers, who have seen their savings diminish since the pandemic began. “We still observe a resilient U.S. consumer overall, but we also see a divergence in performance across different income levels,” he remarked during a recent analyst call.
He indicated that only the top income quartile has maintained more savings than they did at the start of 2019, with those having FICO scores above 740 driving spending growth and upholding high payment rates. In contrast, consumers with lower FICO scores are experiencing a decline in payment rates and are borrowing more as they grapple with elevated inflation and interest rates.
The Federal Reserve is currently holding interest rates at a two-decade high of 5.25-5.5%, awaiting stabilization in inflation toward its 2% target before implementing anticipated rate cuts.
Despite the banks bracing for potential defaults later this year, Mulberry noted that current default rates do not signal an emerging consumer crisis. He is particularly monitoring the differences in housing situations between pandemic homeowners and renters.
“While rates have risen significantly, homeowners secured low fixed rates on their debt, so they’re not feeling the pressure as much as renters who missed that opportunity,” Mulberry explained.
With rents increasing by over 30% nationwide from 2019 to 2023 and grocery costs rising by 25% in the same time frame, renters who couldn’t lock in low rates are experiencing the most strain on their monthly budgets.
For now, the latest earnings reports indicate that there haven’t been new developments in terms of asset quality. Strong revenues, profits, and resilience in net interest income are positive signals for the banking sector’s health.
“There remains strength in the banking sector that may have been somewhat unexpected, but it’s reassuring to see the financial system’s structures are still robust,” Mulberry concluded. “However, we remain vigilant, as persistent high-interest rates will continue to create stress.”