With interest rates reaching over two-decade highs and inflation putting pressure on consumers, major banks are bracing for increased risks tied to their lending practices.
In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all heightened their provisions for credit losses compared to the previous quarter. These provisions represent the funds that banks allocate to cover potential losses from credit risks, including delinquent accounts and bad loans, particularly in commercial real estate (CRE).
JPMorgan reported a provision for credit losses of $3.05 billion in the second quarter; Bank of America contributed $1.5 billion; Citigroup’s allowance for credit losses reached $21.8 billion by the end of the quarter, significantly increasing its reserves from the prior quarter; and Wells Fargo set aside $1.24 billion.
This accumulation indicates that banks are preparing for a challenging environment, where both secured and unsecured loans may lead to higher losses for some of the largest financial institutions in the country. According to a recent analysis by the New York Fed, American households collectively owe $17.7 trillion across consumer loans, student loans, and mortgages.
Additionally, credit card issuance and delinquency rates are on the rise as consumers deplete their savings accumulated during the pandemic and increasingly rely on credit. In the first quarter, credit card balances surpassed $1 trillion for the second consecutive quarter, as reported by TransUnion. Meanwhile, CRE is also facing a precarious situation.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, noted that the banking sector is still recovering from the pandemic, largely due to the consumer stimulus provided during that time.
However, challenges for banks are expected to escalate in the coming months.
Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, explained that the provisions reported in any given quarter do not necessarily represent credit quality from the previous three months but rather reflect banks’ expectations for future conditions.
Narron added, “It’s interesting because we’ve transitioned from a system where provisions increased as loans began to fail, to one where macroeconomic forecasts significantly impact provisioning.”
In the near term, banks forecast slowing economic growth, rising unemployment, and two anticipated interest rate cuts later this year, potentially leading to more delinquencies and defaults as the year concludes.
Citi’s chief financial officer Mark Mason pointed out that potential warning signs appear to be more pronounced among lower-income consumers, who have seen their savings diminish since the pandemic.
“While the overall U.S. consumer remains resilient, there is a noticeable divergence in performance across different income brackets,” Mason remarked during a recent analysts’ call. “Only the highest income quartile has increased their savings since early 2019, and it’s the customers with over a 740 FICO score who are driving spending growth and maintaining high payment rates. Conversely, those in lower FICO bands are experiencing sharp declines in payment rates and are borrowing more, heavily affected by inflation and rising interest rates.”
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5% as it awaits stabilization in inflation toward its 2% target before implementing expected rate cuts.
Despite banks anticipating a rise in defaults in the latter half of the year, Mulberry asserts that defaults have not yet escalated to a level indicating a consumer crisis. He is particularly attentive to the contrast between homeowners and renters during the pandemic.
“While rates have increased significantly, homeowners locked in low fixed rates on their debt, so they are largely insulated from the pain,” Mulberry stated. “Renters, who did not benefit from this opportunity, are facing more stress.”
With a more than 30% increase in rent prices nationwide between 2019 and 2023 and grocery costs rising by 25% in the same timeframe, renters who couldn’t secure low rates are feeling the financial pressure most acutely.
For now, the main takeaway from the latest earnings reports is that there were no significant new trends in terms of asset quality. Instead, strong revenues, profits, and resilient net interest income point towards a still-robust banking sector.
“There’s a resilience in the banking sector that, while not entirely unexpected, is certainly reassuring, indicating that the foundations of the financial system remain solid at this time,” Mulberry concluded. “However, we are monitoring the situation closely, as prolonged high interest rates will inevitably result in increased stress.”