With interest rates reaching their highest levels in over two decades and inflation putting pressure on consumers, major banks are preparing to mitigate risks associated with their lending practices.
In the second quarter, prominent banks such as JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo increased their provisions for credit losses compared to the previous quarter. These provisions are the funds set aside by financial institutions to cover potential losses due to credit risk, including delinquent or bad debts and loans, particularly in the commercial real estate sector.
JPMorgan allocated $3.05 billion for credit loss provisions in the second quarter; Bank of America set aside $1.5 billion; Citigroup’s allowance for credit losses amounted to $21.8 billion at the end of the quarter, more than tripling its reserves from the prior quarter; while Wells Fargo provided $1.24 billion for the same purpose.
These reserve increases indicate that banks are preparing for a more challenging economic environment, where both secured and unsecured loans may lead to increased losses for some of the largest banks in the country. A recent report from the New York Federal Reserve revealed that Americans collectively owe $17.7 trillion in consumer loans, student loans, and mortgages.
Credit card issuance and delinquency rates are also on the rise as individuals deplete their pandemic-era savings and increasingly rely on credit. Credit card balances reached $1.02 trillion in the first quarter of 2023, marking the second consecutive quarter where the total exceeded the trillion-dollar threshold, according to TransUnion. Additionally, the commercial real estate sector continues to face significant challenges.
The impact of the ongoing economic recovery from the COVID-19 pandemic is evident, as noted by Brian Mulberry, a client portfolio manager at Zacks Investment Management. He emphasized that much of the prior consumer health was aided by government stimulus.
Looking ahead, any challenges faced by banks are expected in the coming months. Mark Narron, a senior director at Fitch Ratings, stated that provisions reported by banks do not necessarily reflect current credit quality but instead represent banks’ expectations for the future.
He pointed out a shift from a historic approach where provisions increased only when loans defaulted to a new paradigm driven by macroeconomic forecasting.
In the near term, banks anticipate slowed economic growth, a rising unemployment rate, and two interest rate cuts later this year, potentially leading to more delinquencies and defaults by year-end.
Mark Mason, Citigroup’s chief financial officer, highlighted that the warning signs appear to be primarily among lower-income consumers, who have seen their savings diminish since the pandemic began.
Mason said, “While we continue to see an overall resilient U.S. consumer, we also continue to see a divergence in performance and behavior across income levels.” He noted that only the highest-income quartile has increased their savings since early 2019, while those with lower credit scores are facing sharper drops in payment rates and borrowing more due to the impacts of inflation and rising interest rates.
The Federal Reserve maintains interest rates at a 23-year high of 5.25-5.5% as it awaits signs of inflation stabilizing towards its 2% target before implementing expected rate cuts.
Despite the anticipated rise in defaults in the latter half of the year, analysts believe that current default rates do not indicate a consumer crisis. Mulberry is particularly attentive to the differences between homeowners who locked in low fixed rates during the pandemic and renters who missed that opportunity.
He pointed out that although interest rates have surged, homeowners are not experiencing the same financial strain due to their fixed-rate mortgages. Meanwhile, renters, who are dealing with rising rents and grocery prices, are facing significant budgetary pressures.
However, the overall message from the latest earnings reports indicates stability in the banking sector, with no new concerns about asset quality. Strong revenues and profit margins, along with robust net interest income, suggest a healthy banking environment.
Mulberry concluded that the banking sector remains strong and sound at present but acknowledged that prolonged high interest rates could create additional stress moving forward.