With interest rates reaching levels not seen in over two decades and inflation continuing to pressure consumers, major banks are bracing for increased risks related to their lending practices.
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 represent funds that financial institutions set aside to mitigate potential losses from credit risks, including defaulting loans and bad debt.
JPMorgan allocated $3.05 billion for credit losses in the second quarter; Bank of America set aside $1.5 billion; Citigroup’s credit loss allowance rose to $21.8 billion by the quarter’s end, more than tripling its reserve build from the previous quarter; and Wells Fargo recorded provisions of $1.24 billion.
These growing reserves indicate that banks are preparing for a more challenging lending environment where both secured and unsecured loans may lead to larger losses. The New York Federal Reserve recently reported that U.S. households collectively owe $17.7 trillion in consumer loans, student loans, and mortgages.
The issuance of credit cards is rising, along with increased delinquency rates, as pandemic-era savings dwindle and consumers rely more on 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 a trillion dollars, according to TransUnion. Additionally, commercial real estate (CRE) remains in a vulnerable state.
“We are still emerging from the COVID era, and the health of the consumer has largely been supported by the stimulus that was deployed,” said Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, challenges for banks are anticipated in the upcoming months.
“The provisions you see each quarter do not necessarily reflect credit quality from the previous three months; they indicate what banks expect to happen in the future,” explained Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
This shift in how provisions are calculated means that macroeconomic forecasts now play a critical role in provisioning, rather than just historical loan performance.
In the short term, banks are anticipating slower economic growth, higher unemployment, and two interest rate cuts later this year in September and December, possibly leading to more delinquencies and defaults as the year closes.
Citigroup’s Chief Financial Officer Mark Mason highlighted that these concerning trends are primarily evident among lower-income consumers, who have seen their savings deplete over the years post-pandemic.
“While we see an overall resilient U.S. consumer, there is a noticeable disparity in performance and behavior across income and FICO score bands,” Mason stated during a recent analyst call. “Only the highest income quartile has more savings today than at the start of 2019, and the rise in spending and high payment rates is driven by customers with FICO scores over 740. Conversely, those in lower FICO bands are experiencing declining payment rates and are borrowing more as they feel the brunt of high inflation and interest rates.”
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5%, awaiting stabilization in inflation towards the central bank’s 2% target before initiating the anticipated rate cuts.
Despite preparing for potential increased defaults in the latter half of the year, current default rates do not yet indicate a consumer crisis, according to Mulberry. He emphasizes the contrast between homeowners who secured low fixed rates during the pandemic and renters who did not.
“Homeowners may have adjusted to rising rates since they locked in low fixed rates on their debt and are not feeling the immediate pressure,” Mulberry noted. “Renters, on the other hand, did not have that opportunity.”
With rents climbing more than 30% nationwide between 2019 and 2023 and grocery costs increasing by 25%, renters struggling with rising rental costs that outpace wage growth are experiencing significant pressure on their budgets.
For the time being, the key takeaway from the most recent earnings reports is that “there were no significant updates this quarter regarding asset quality,” according to Narron. The sector is showing strong revenues, profits, and resilient net interest income, all suggesting a healthy banking landscape.
“There’s strength in the banking sector, which may not have been entirely unexpected, but it’s certainly reassuring to confirm that the financial system remains strong and sound at this point,” said Mulberry. “However, we are closely monitoring the situation, as prolonged high interest rates will create more stress.”