With interest rates reaching their highest levels in over 20 years and inflation continuing to pressure consumers, major banks are bracing for increased risks associated with their lending activities.
In the second quarter, major financial institutions including 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 that banks allocate to cover potential losses arising from credit risks, such as delinquent debts or issues related to commercial real estate loans.
JPMorgan set aside $3.05 billion for credit losses during the second quarter; Bank of America recorded $1.5 billion; Citigroup’s allowance totaled $21.8 billion by the end of the quarter, representing a significant increase from the prior period; and Wells Fargo added $1.24 billion in provisions.
The increase in provisions reflects banks’ anticipation of a more challenging financial environment, where both secured and unsecured loans could result in greater losses. According to a recent analysis by the New York Fed, American households hold a combined debt of $17.7 trillion across various consumer loans, student loans, and mortgages.
Credit card issuance is rising, along with delinquency rates, as many consumers exhaust their pandemic-era savings and increasingly rely on credit. TransUnion reported that credit card balances surpassed $1 trillion in the first quarter, marking the second consecutive quarter to exceed this threshold. The commercial real estate sector also faces ongoing challenges.
“We are still in the aftermath of the COVID pandemic, particularly regarding banking and consumer health, which has largely depended on the stimulus provided to consumers,” stated Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, the real impact on banks may become clearer in the coming months.
“The provisions listed for any quarter do not necessarily reflect credit quality for that period; they indicate what banks anticipate will occur in the future,” explained Mark Narron, a senior director at Fitch Ratings’ Financial Institutions Group.
He noted the shift from a traditional model where provisions increased as loans worsened, to a system where macroeconomic forecasts primarily determine provisioning practices.
In the short term, banks expect slower economic growth, rising unemployment, and two interest rate cuts anticipated later this year in September and December, which could lead to more delinquencies and defaults as the year comes to a close.
Citi’s chief financial officer Mark Mason pointed out troubling trends among lower-income consumers, whose savings have declined significantly since the pandemic began.
“While the overall U.S. consumer remains resilient, there are noticeable differences in performance based on income and credit scores,” Mason told analysts recently. “Our data shows that only the highest income quartile has more savings now compared to the beginning of 2019, with those holding FICO scores above 740 driving spending growth and maintaining high payment rates. In contrast, lower FICO score consumers are experiencing declining payment rates and increased borrowing, particularly impacted by high inflation and interest rates.”
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5%, holding off on cuts until inflation shows signs of stabilizing towards the target of 2%.
Despite banks preparing for potential increases in defaults later this year, experts suggest that defaults have not yet escalated to a level indicative of a consumer crisis. Mulberry noted that he is observing a divide between homeowners who secured low fixed-rate mortgages during the pandemic and renters who have not had the same opportunity.
“While interest rates have surged, homeowners locked in low rates and are not feeling significant distress,” Mulberry explained. “In contrast, renters have faced a 30% increase in rents since 2019, with grocery prices also rising by 25%, creating significant stress for those whose wages have not kept pace with rental costs.”
Currently, the most significant conclusion from the recent earnings reports is that “there was nothing novel in terms of asset quality this quarter,” according to Narron. Strong revenues, profits, and robust net interest income are encouraging signs of a still-stable banking sector.
“There remains a foundation of strength in the banking sector that is somewhat reassuring, indicating that the financial system remains sound at this moment,” Mulberry added. “However, as long as interest rates remain elevated, increasing strain is inevitable.”