As interest rates reach levels not seen in over 20 years and inflation continues to pressure consumers, major banks are bracing for increased risks associated with their lending activities.
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 funds set aside by financial institutions to cover potential losses from credit risk, which includes bad debts and defaults on loans, particularly in commercial real estate (CRE).
JPMorgan established $3.05 billion in provisions for credit losses, while Bank of America set aside $1.5 billion. Citigroup’s allowance for credit losses reached $21.8 billion at the close of the quarter, more than tripling its reserves from the prior period, and Wells Fargo set its provisions at $1.24 billion.
These precautionary measures indicate that banks are preparing for a challenging financial environment, where both secured and unsecured loans may lead to greater losses. A recent analysis from the New York Fed highlighted that American households collectively owe $17.7 trillion in consumer loans, student loans, and mortgages.
Furthermore, credit card issuance and delinquency rates are rising as consumers exhaust their pandemic-era savings and turn increasingly to credit. According to TransUnion, credit card balances hit $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where total cardholder balances surpassed the trillion-dollar threshold. The commercial real estate sector also remains in a vulnerable state.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, commented, “We’re still emerging from the COVID era, particularly regarding banking and consumer health, largely due to the stimulus provided to consumers.”
However, experts suggest that any challenges for banks are likely to manifest in the upcoming months. “The provisions you see in any given quarter do not necessarily reflect credit quality for the last three months but what banks anticipate happening in the future,” said Mark Narron, a senior director at Fitch Ratings’ Financial Institutions Group.
He added, “It’s interesting to note that we’ve shifted from a system where provisions increased after loans began to default to one where macroeconomic forecasts drive provisioning.”
In the short term, banks expect a slowdown in economic growth, rising unemployment rates, and potential interest rate cuts later this year. This could lead to increased delinquencies and defaults by year-end.
Citi’s Chief Financial Officer Mark Mason pointed out that warning signs are particularly evident among lower-income consumers who have seen their savings diminish significantly since the pandemic. “While the overall U.S. consumer remains resilient, we observe a divergence in performance and behavior based on FICO scores and income levels,” he stated.
Mason noted that only the top income quartile has more savings than at the start of 2019, with customers holding high FICO scores driving spending growth and maintaining timely payments. In contrast, those with lower FICO scores are experiencing drops in payment rates and are borrowing more, feeling the impact of high inflation and interest rates more acutely.
As the Federal Reserve maintains interest rates at a 23-year high of 5.25-5.5%, waiting for inflation to stabilize towards its 2% target, banks are gearing up for potential defaults in the latter half of the year. However, Mulberry believes that current default rates do not yet indicate a consumer crisis. He observes a distinction between homeowners from the pandemic era and renters.
Despite the significant rise in interest rates since that time, homeowners benefiting from low fixed-rate mortgages are less affected, whereas renters face escalating costs in their budgets due to rising rents and grocery prices.
For now, the latest earnings reports suggest stability in asset quality. Narron remarked, “It is clear that the banking industry is performing well, showcasing strong revenues and profits, and resilient net interest income.” Mulberry echoed this sentiment, stating, “There’s strength in the banking sector that is reassuring, but we are monitoring the ongoing impact of high interest rates closely.”