As interest rates reach over two-decade highs and inflation weighs on 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 that banks set aside to cover potential losses stemming from credit risk, including bad debts and commercial real estate (CRE) loans.
JPMorgan set aside $3.05 billion for credit losses during the second quarter, while Bank of America allocated $1.5 billion. Citigroup reported a total of $21.8 billion in allowances for credit losses, more than tripling its reserve from the previous quarter. Wells Fargo’s provisions amounted to $1.24 billion.
These increased reserves indicate that banks are preparing for a more challenging environment where both secured and unsecured loans could lead to greater losses. A recent study by the New York Federal Reserve revealed that U.S. households owe a total of $17.7 trillion in various consumer debts, including student loans and mortgages.
Credit card issuance and delinquency rates are also rising as many people deplete their pandemic savings and increasingly rely on credit. Credit card balances reached $1.02 trillion in the first quarter of this year, marking the second consecutive quarter that total balances surpassed the trillion-dollar threshold, according to TransUnion. The commercial real estate sector continues to face uncertainties as well.
“We’re still emerging from the COVID era, particularly in banking and consumer health, largely due to the stimulus that was provided,” said Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, challenges for banks are anticipated in the coming months.
“The provisions seen in any quarter do not necessarily reflect credit quality from the past three months; they reflect banks’ expectations for the future,” explained Mark Narron, a senior director at Fitch Ratings’ Financial Institutions Group.
Narron added that the focus has shifted from a system where rising loan defaults prompted an increase in provisions to one where macroeconomic forecasts largely dictate provisioning practices.
In the near future, banks expect to see slower economic growth, an uptick in unemployment, and two projected interest rate cuts in September and December. This scenario could lead to a higher number of delinquencies and defaults as the year concludes.
Citi’s chief financial officer Mark Mason pointed out that the emerging red flags primarily affect lower-income consumers whose savings have diminished since the pandemic began.
“While the overall U.S. consumer remains resilient, disparities in performance and behavior across different income and FICO bands are evident,” Mason noted during a recent analysts’ call. He observed that only the top income quartile has more savings now compared to early 2019, and those with FICO scores above 740 are largely responsible for increased spending and maintaining high payment rates.
Under the current economic landscape, The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5%, pausing any cuts until inflation measures align more closely with the central bank’s 2% target.
Despite preparing for possible defaults later in the year, experts like Mulberry have not yet observed a rising default rate indicative of a consumer crisis. He is particularly focused on the differences between homeowners and renters during the pandemic.
“Although interest rates have significantly increased, homeowners locked in low fixed rates on their debts and are not feeling substantial pain at this time,” Mulberry explained. “In contrast, renters who haven’t benefitted from these low rates are struggling as rents have surged more than 30% nationally since 2019 and grocery prices have risen by 25%, all while wages have not kept pace.”
For now, a key takeaway from the recent earnings reports is that “there were no significant changes in asset quality,” according to Narron. Strong revenues and profits alongside healthy net interest income suggest a stable banking sector.
“There’s an underlying strength in the banking industry that might not have been entirely expected, yet it’s reassuring to confirm that the financial system’s foundations remain solid,” Mulberry stated. “However, we remain vigilant; prolonged high-interest rates will continue to exert pressure.”