As interest rates remain at their highest levels in over two decades and inflation continues to affect consumers, major banks are bracing for increased risks associated with their lending activities.
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 are funds set aside by financial institutions to cover possible credit losses, including bad debt and problems related to lending, particularly commercial real estate loans.
JPMorgan allocated $3.05 billion for credit losses in the second quarter, while Bank of America set aside $1.5 billion. Citigroup’s allowance for credit losses reached $21.8 billion at the end of the quarter, which more than tripled its reserve build from the previous quarter, and Wells Fargo established provisions of $1.24 billion.
These increased provisions reflect banks’ preparation for a riskier financial environment, where both secured and unsecured loans may lead to larger losses for some of the largest banking institutions. A recent analysis by the New York Federal Reserve found that Americans owe a total of $17.7 trillion in various types of consumer debt.
The issuance of credit cards and the associated delinquency rates have also been on the rise as people begin to deplete their savings amassed during the pandemic. 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 exceeded the trillion-dollar mark. Additionally, the commercial real estate sector remains troubled.
“We are still recovering from the COVID era, particularly in terms of banking and consumer health, largely due to the stimulus provided to consumers,” said Brian Mulberry, a client portfolio manager at Zacks Investment Management.
Any potential issues for banks, however, are expected to manifest in the coming months. “The provisions observed in any quarter do not necessarily reflect credit quality from the past three months but rather what banks anticipate will occur in the future,” explained Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
He noted a shift from a system where increased loan defaults resulted in higher provisions to one where macroeconomic forecasts significantly influence provisioning decisions.
In the short term, banks are anticipating slower economic growth, higher unemployment rates, and two interest rate cuts later this year, which could lead to more delinquencies and defaults by year’s end.
Citi’s Chief Financial Officer Mark Mason highlighted that these concerns seem to be primarily affecting lower-income consumers, who have seen their savings diminish post-pandemic. “While we observe an overall resilient U.S. consumer, there is a notable divergence in performance and behavior across different income levels,” Mason stated during a recent analyst call.
He explained that only the highest income group has maintained savings above pre-pandemic levels, while individuals with FICO scores over 740 are driving spending growth and sustaining high payment rates. Conversely, customers with lower FICO scores are experiencing significant drops in payment rates and are relying more on borrowing due to the pressures of high inflation and rising interest rates.
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5%, waiting for inflation to stabilize towards its 2% target before implementing anticipated rate cuts.
Despite banks preparing for an increase in defaults in the latter half of the year, current default rates do not indicate an imminent consumer crisis, according to Mulberry. He is particularly observing the contrast between homeowners and renters during the pandemic.
“Although rates have risen considerably, homeowners secured low fixed rates on their debts, so they are not experiencing as much financial pain. Renters, on the other hand, have not had that advantage,” he explained.
With rents surging over 30% nationwide between 2019 and 2023 and grocery prices rising by 25% during the same period, renters—who did not benefit from locking in low rates—are under significant financial stress.
Currently, the most significant takeaway from the recent earnings reports is that there haven’t been notable changes in asset quality. Strong revenues, profits, and robust net interest income are encouraging signs for a banking sector that remains fundamentally sound.
“There is some strength in the banking sector that may not have been entirely anticipated, but it is reassuring to find that the foundations of the financial system are still solid. However, we are monitoring the situation closely; the longer interest rates remain elevated, the more stress it will create,” Mulberry concluded.