With interest rates reaching their highest levels in over two decades and inflation continuing to press on consumers, major banks are preparing for increased risks associated with their lending practices.
In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all enhanced their provisions for credit losses compared to the previous quarter. These provisions are the reserves that banks set aside to manage potential losses stemming from credit risks, including defaults on debts and loans, particularly in the commercial real estate sector.
JPMorgan allocated $3.05 billion for credit losses in the second quarter; Bank of America set aside $1.5 billion; Citi’s allowance for credit losses surged to $21.8 billion by the end of the quarter, representing a more than tripled reserve increase from the previous quarter; and Wells Fargo reported provisions of $1.24 billion.
This buildup indicates that banks are bracing themselves for a more challenging lending environment, where both secured and unsecured loans could lead to significant losses for some of the largest financial institutions. Recent findings from the New York Federal Reserve revealed that total household debt has reached $17.7 trillion, encompassing consumer loans, student loans, and mortgages.
Both the issuance of credit cards and delinquency rates are on the rise as consumers deplete their savings accumulated during the pandemic and increasingly rely on credit. Credit card balances hit $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where the total has surpassed a trillion dollars, according to TransUnion. The commercial real estate sector also continues to face uncertainties.
“We’re still recovering from the COVID era, particularly regarding banking and consumer health, which was largely supported by stimulus measures provided to consumers,” said Brian Mulberry, a client portfolio manager with Zacks Investment Management.
However, any troubles for banks are expected to emerge in the coming months.
“The provisions reported for any quarter do not necessarily reflect the credit quality over the last three months; they indicate banks’ expectations for the future,” said Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
He commented on the evolution of the banking industry, stating, “It’s interesting because we’ve transitioned from a historical model where rising loan defaults led to increased provisions, to a model driven by macroeconomic forecasts.”
In the immediate future, banks anticipate slower economic growth, higher unemployment rates, and potential interest rate cuts later this year in September and December, which could result in increased delinquencies and defaults as the year concludes.
Citi’s chief financial officer Mark Mason pointed out that these warning signs appear to be primarily affecting lower-income consumers, whose savings have diminished since the pandemic began.
“While the overall U.S. consumer remains resilient, there’s a noticeable divergence in performance and behavior across different income levels and credit scores,” Mason noted during a recent call with analysts.
Among their consumer clients, he’s observed that only the highest income quartile has managed to retain more savings than they had at the beginning of 2019, and it is primarily customers with scores over 740 that are driving spending growth while maintaining high payment rates. In contrast, those in lower credit score bands are experiencing more significant drops in payment rates and increasing their borrowing due to heightened 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 measures towards its 2% target before making anticipated rate cuts.
Although banks are gearing up for a possible increase in defaults later this year, Mulberry indicated that current default rates do not signal a consumer crisis. He is closely monitoring the differences between homeowners from the pandemic period and renters.
“Although rates have risen significantly since then, homeowners have locked in very low fixed rates, so they are not feeling the pinch as much,” Mulberry explained. “Renters, however, who did not secure low rates, are now facing rental prices that have surged over 30% since 2019, compounded by a 25% increase in grocery costs during the same timeframe. They are thus feeling the greatest strain on their monthly budgets.”
For now, the main takeaway from the latest earnings reports is that there were no significant changes in terms of asset quality, according to Narron. Strong revenues, profits, and a resilient net interest income remain positive signs for a still-stable banking sector.
“There is a degree of strength in the banking sector that wasn’t entirely unexpected, but it’s certainly reassuring to observe that the financial system’s foundations remain robust,” Mulberry remarked. “Nonetheless, we are closely monitoring the situation, as prolonged high interest rates could lead to additional stress.”