With interest rates at their highest levels in over 20 years and inflation affecting consumers, major banks are bracing for increased risks linked to their lending practices.
In the second quarter, leading financial institutions including JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo raised their provisions for credit losses compared to the previous quarter. These provisions represent funds set aside to manage potential losses from credit risk, encompassing areas such as delinquent debts and various types of lending, notably commercial real estate (CRE) loans.
JPMorgan allocated $3.05 billion for credit loss provisions in the second quarter, while Bank of America set aside $1.5 billion. Citigroup’s allowance for credit losses rose sharply to $21.8 billion by the end of the quarter, more than tripling its reserves from the previous period. Wells Fargo recorded provisions totaling $1.24 billion.
These increased reserves indicate that banks are preparing for riskier circumstances, where both secured and unsecured loans could lead to greater losses. According to the New York Fed, American households collectively owe $17.7 trillion in consumer loans, student loans, and mortgages.
Credit card issuance and delinquency rates are also on the rise as people exhaust their pandemic savings and increasingly turn to credit. Credit card balances reached $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where total cardholder balances surpassed the trillion-dollar threshold, as reported by TransUnion. The commercial real estate sector also remains under pressure.
“We are still emerging from the COVID era, and the health of the consumer has largely been supported by stimulus measures,” said Brian Mulberry, a portfolio manager at Zacks Investment Management.
However, the challenges for banks are expected to manifest in the coming months.
“The provisions seen in any quarter do not necessarily reflect credit quality for the preceding three months; rather, they indicate banks’ expectations for the future,” explained Mark Narron, a senior director at Fitch Ratings’ Financial Institutions Group.
He added that unlike in the past, when loan defaults led to increased provisions, the current system is driven by macroeconomic forecasts.
In the near future, banks are anticipating slower economic growth, a rise in unemployment, and two interest rate cuts planned for September and December. This scenario points to a potential increase in delinquencies and defaults by year-end.
Citi’s Chief Financial Officer Mark Mason highlighted that these concerns are particularly evident among lower-income consumers, whose savings have diminished since the pandemic.
“While the U.S. consumer overall remains resilient, there are stark differences in performance and behavior based on income and credit scores,” said Mason in a recent analyst call.
He noted that only the top income quartile has managed to retain more savings since early 2019, with those scoring above 740 on their FICO scores driving spending growth and maintaining high payment rates. Conversely, lower FICO score customers have been experiencing significant declines in payment rates while borrowing more amid the pressures of inflation and rising interest costs.
The Federal Reserve has maintained interest rates between 5.25% and 5.5%, their highest in 23 years, as it seeks stabilization of inflation around its 2% target before implementing expected rate cuts.
Despite banks preparing for an increase in defaults later this year, Mulberry states that current default rates do not yet indicate a consumer crisis. He emphasizes the distinction between homeowners and renters during the pandemic.
“While interest rates have risen significantly, homeowners locked in low fixed rates and aren’t feeling the strain as acutely,” Mulberry said, highlighting the struggles of renters who have faced rising costs without the benefit of low-rate mortgages.
Rents have surged over 30% nationwide from 2019 to 2023, and grocery prices have climbed by 25% during the same period. This has resulted in financial stress for renters whose wages have not kept pace with escalating expenses.
Overall, the latest earnings round suggests that “there was nothing new this quarter in terms of asset quality,” according to Narron. Strong revenues, profits, and robust net interest income are reassuring signs of a healthy banking sector.
“There is resilience in the banking sector, which is somewhat expected, but reassuring, as the financial system remains strong and stable at this moment,” Mulberry concluded. “However, the longer interest rates remain at high levels, the greater the potential stress.”