With interest rates reaching their highest level in over 20 years and inflation continuing to pressure consumers, major banks are bracing for increased risks in their lending operations.
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 the funds that banks set aside to cover potential losses from credit risks, including defaulted loans and issues with commercial real estate (CRE) lending.
JPMorgan allocated $3.05 billion for credit losses in the second quarter, while Bank of America set aside $1.5 billion. Citigroup’s credit loss allowance reached $21.8 billion, marking an increase of more than threefold from the prior quarter. Wells Fargo established provisions totaling $1.24 billion.
These increased provisions indicate that banks are preparing for a more challenging economic environment, where both secured and unsecured loans could lead to greater losses for some of the largest financial institutions. A recent analysis of household debt by the New York Federal Reserve found that Americans collectively owe $17.7 trillion in consumer loans, student loans, and mortgages.
The issuance of credit cards and subsequent delinquency rates are also rising as individuals draw down their pandemic savings and increasingly rely on credit. According to TransUnion, total credit card balances reached $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where the overall credit card balances surged beyond the trillion-dollar threshold. Additionally, the commercial real estate sector continues to face significant challenges.
“We’re still emerging from the COVID period, mainly regarding banking and consumer health, largely due to the stimulus measures introduced,” commented Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, potential issues for banks may manifest in the upcoming months. “The provisions reported in any quarter do not necessarily reflect the credit quality over the last three months; rather, they represent what banks anticipate for the future,” explained Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
“The shift has been from a model where increasing defaults prompted higher provisions to one where macroeconomic forecasts drive provisioning,” he added.
Looking forward, banks are predicting slower economic growth, a higher unemployment rate, and two interest rate cuts expected later this year, which may lead to increased delinquencies and defaults as 2023 approaches its end.
Citi’s chief financial officer Mark Mason highlighted that these warning signs seem to be primarily affecting lower-income consumers, whose savings have diminished since the pandemic. “While the U.S. consumer remains resilient overall, we observe performance disparities across different income levels,” Mason stated in a recent analyst call.
He noted that only the highest income quartile has been able to increase their savings since early 2019, and it is primarily individuals with credit scores above 740 driving spending growth and maintaining high payment rates. In contrast, lower credit score customers are experiencing significant drops in payment rates and increased borrowing due to heightened inflation and interest rates.
The Federal Reserve has maintained interest rates between 5.25% and 5.5%—the highest in 23 years—as it waits for inflation metrics to stabilize towards the central bank’s 2% target before implementing anticipated rate cuts.
Despite the preparations for a potential rise in defaults in the latter half of the year, current default rates do not indicate an impending consumer crisis, according to Mulberry. He is particularly attentive to the distinction between homeowners and renters during this period.
“Although interest rates have increased significantly since then, homeowners locked in low fixed rates, so they are not feeling the pressure as much,” said Mulberry. “Conversely, renters, who missed that opportunity, are now contending with rents that have surged over 30% nationwide since 2019 and food prices rising by 25% in this same timeframe, causing financial strain.”
Currently, the key takeaway from the recent earnings reports is that “there were no new concerns this quarter regarding asset quality,” Narron noted. In fact, robust revenues, profits, and solid net interest income are all indicators of a still-stable banking sector.
“There is some strength in the banking sector that may not have been entirely unexpected, but it certainly reassures us that the financial system remains strong and sound at this moment,” Mulberry concluded. “However, we must monitor the situation closely as prolonged high-interest rates will invariably increase pressure.”