As interest rates remain at levels not seen in over two decades and inflation continues to impact 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 increased their provisions for credit losses compared to the previous quarter. These provisions represent funds set aside by financial institutions to mitigate potential losses due to credit risks, including delinquencies and bad debt linked to loans, such as commercial real estate loans.
JPMorgan allocated $3.05 billion for credit losses, while Bank of America set aside $1.5 billion. Citigroup’s credit loss allowance amounted to $21.8 billion at the end of the quarter, more than tripling its reserves from the prior period. Wells Fargo’s provisions totaled $1.24 billion.
These increased provisions indicate that banks are bracing for a more challenging environment, where both secured and unsecured loans could lead to larger losses for some of the largest banks in the country. A recent analysis by the New York Fed revealed that American household debt has reached a staggering $17.7 trillion, encompassing consumer loans, student loans, and mortgages.
In addition, credit card issuance and delinquency rates are rising as individuals are depleting their savings accumulated during the pandemic and increasingly relying on credit. According to TransUnion, 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. Moreover, the commercial real estate sector remains in a tenuous position.
“We are still emerging from the COVID era, and the consumer’s financial health has been closely tied to the stimulus provided during that time,” stated Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, any issues that may arise for banks are anticipated in the coming months.
“The provisions reflected in each quarter do not necessarily illustrate credit quality for the last three months; instead, they represent banks’ expectations for the future,” explained Mark Narron, senior director of Fitch Ratings’ Financial Institutions Group.
Narron added that there has been a shift from the traditional system where provisions increased when loans began to fail, to a model where macroeconomic forecasts significantly influence provisioning decisions.
In the short term, banks are forecasting a slowdown in economic growth, along with a rise in unemployment rates and two anticipated interest rate cuts later this year, potentially in September and December. These conditions may lead to increased delinquencies and defaults by year-end.
Citi’s chief financial officer Mark Mason noted that these risk indicators are particularly evident among lower-income consumers, whose savings have diminished in the years following the pandemic.
“While we continue to see overall resilience in the U.S. consumer, there is a noticeable divergence in performance and behavior among different income and credit score groups,” Mason commented in a recent analyst call.
He highlighted that only the highest income quartile has more savings than at the beginning of 2019, with those scoring over 740 on the FICO scale driving spending growth and maintaining high payment rates. In contrast, lower FICO score customers are experiencing sharper declines in payment rates and are borrowing more, feeling the effects of high inflation and interest rates more acutely.
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5%, awaiting stabilization in inflation metrics toward its 2% target before implementing anticipated rate cuts.
Even with banks preparing for potential widespread defaults in the latter part of the year, current default rates have not yet reached a level indicative of a consumer crisis, according to Mulberry. He is particularly observant of the contrast between homeowners and renters during the pandemic.
“While rates have increased significantly, homeowners locked in low fixed rates on their debts and are not feeling the pinch as much,” Mulberry remarked. “Renters, who did not have that opportunity, are facing different challenges.”
With rents rising over 30% nationwide between 2019 and 2023 and grocery prices increasing by 25% during the same period, renters who failed to secure low rates are experiencing the most financial strain relative to their income, Mulberry noted.
Nonetheless, the overarching theme from recent earnings reports is that there have been no significant changes in asset quality. Strong revenues, profitability, and resilient net interest income indicate a robust banking sector.
“There is a degree of strength in the banking sector that perhaps wasn’t completely anticipated, but it is reassuring to observe that the financial system’s frameworks remain solid and secure at this time,” Mulberry concluded. “However, we continue to monitor the situation closely, as prolonged periods of high interest rates could introduce additional stress.”