As interest rates remain at their highest levels in over two decades and inflation continues to challenge consumers, major banks are preparing for potential risks linked to 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 represent funds set aside by financial institutions to address possible losses due to credit risk, such as delinquent or bad debt and lending practices, particularly in commercial real estate (CRE).
JPMorgan allocated $3.05 billion for credit loss provisions during the second quarter while Bank of America set aside $1.5 billion. Citi’s allowance for credit losses reached $21.8 billion by the end of the quarter, marking a more than threefold increase from the previous quarter. Wells Fargo noted provisions of $1.24 billion.
The increase in reserves indicates that banks are preparing for a challenging environment where both secured and unsecured loans may lead to significant losses. The New York Fed recently reported that Americans collectively owe $17.7 trillion on consumer loans, student loans, and mortgages.
Additionally, credit card issuance and delinquency rates are rising as consumers exhaust their pandemic-era savings and increasingly rely on credit. Credit card balances surpassed $1 trillion for the second consecutive quarter in the first quarter of this year, according to TransUnion. The CRE sector also remains under pressure.
According to Brian Mulberry, a client portfolio manager at Zacks Investment Management, the economic recovery from the COVID era has been supported by extensive stimulus measures directed at consumers.
However, potential challenges for banks are expected in the coming months. Mark Narron, a senior director at Fitch Ratings, explained that the provisions recorded by banks in any given quarter do not necessarily reflect recent credit quality but rather what banks anticipate will happen moving forward.
Currently, banks foresee a slowdown in economic growth, an increase in unemployment, and anticipate interest rate cuts in September and December. This scenario suggests that there may be more delinquencies and defaults as the year concludes.
Citi’s CFO Mark Mason highlighted that the emerging red flags predominantly affect lower-income consumers, who have experienced a decline in savings since the pandemic.
Despite an overall resilient U.S. consumer sector, Mason mentioned a noticeable disparity in performance across different income levels and FICO scores. He noted that only the highest income quartile has maintained more savings compared to early 2019, with customers boasting FICO scores over 740 driving spending growth and high payment rates. In contrast, those in lower FICO bands are witnessing declining payment rates and are borrowing more due to the pressures of high inflation and interest rates.
The Federal Reserve has kept interest rates at a 23-year high of 5.25-5.5% as it awaits stabilization in inflation rates toward its 2% target before implementing expected rate cuts.
Despite banks bracing for increased defaults in the latter half of the year, current data does not indicate a consumer crisis. Mulberry noted that a crucial observation will be the difference between homeowners and renters during the pandemic. Homeowners, who secured low fixed rates on their debt, are less impacted compared to renters who did not benefit from such rates amid rising costs.
With rent prices having increased over 30% nationwide from 2019 to 2023 and grocery costs up by 25%, renters without the advantage of low rates are experiencing significant strain on their budgets.
Nevertheless, the latest earnings reports reveal no new concerns regarding asset quality. Strong revenues, profits, and resilient net interest income reflect a still-stable banking sector.
According to Mulberry, while some strength in the banking system was anticipated, it is reassuring to observe that the financial structures remain robust. However, he cautioned that prolonged high interest rates could exert additional stress on the system.