With interest rates at more than two-decade highs and inflation continuing to impact consumers, major banks are gearing up to face increased risks from their lending practices.
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 potential losses from credit risk, including delinquent or bad debt and lending, such as commercial real estate (CRE) loans.
JPMorgan built up $3.05 billion in provision for credit losses in the second quarter; Bank of America had $1.5 billion in reserves; Citigroup’s allowance for credit losses totaled $21.8 billion at the end of the quarter, more than tripling its credit reserve from the prior quarter; and Wells Fargo had provisions of $1.24 billion.
These increased reserves indicate that banks are preparing for a riskier environment, where both secured and unsecured loans could lead to greater losses. A recent analysis of household debt by the New York Federal Reserve found that Americans owe a collective $17.7 trillion on consumer loans, student loans, and mortgages.
Credit card issuance and delinquency rates are also on the rise as people deplete their pandemic-era savings and rely more on credit. Credit card balances totaled $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where the total of all cardholder balances exceeded the trillion-dollar mark, according to TransUnion. Additionally, CRE remains precarious.
“We’re still emerging from the COVID era, and, particularly in banking and consumer health, it was all the stimulus that was directed to consumers,” said Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, any problems for banks will manifest in the coming months.
“The provisions observed in any given quarter don’t necessarily reflect credit quality for the last three months; they reflect banks’ future expectations,” said Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
“It’s interesting because we’ve shifted from a system where provisions increased when loans started to go bad to one where macroeconomic forecasts drive provisioning,” he added.
In the near term, banks are anticipating slower economic growth, a higher unemployment rate, and two interest rate cuts later this year in September and December, Narron said. This could result in more delinquencies and defaults by the end of the year.
Citigroup’s chief financial officer Mark Mason noted that these warning signs are concentrated among lower-income consumers, who have seen their savings dwindle since the pandemic.
“While we continue to see an overall resilient U.S. consumer, we also see a divergence in performance and behavior across FICO and income bands,” Mason said earlier this month.
“When examining our consumer clients, only the highest income quartile has more savings than they did at the beginning of 2019, and it is consumers with over-740 FICO scores who are driving spending growth and maintaining high payment rates,” he said. “Lower FICO score customers are seeing sharper drops in payment rates and borrowing more as they are more significantly impacted by high inflation and interest rates.”
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5%, as it waits for inflation measures to stabilize towards the central bank’s 2% target before carrying out the anticipated rate cuts.
Even as banks brace for wider defaults later in the year, defaults are not yet rising at a rate indicative of a consumer crisis, according to Mulberry. He’s monitoring the difference between those who owned homes during the pandemic and renters.
“Yes, rates have significantly increased since then, but homeowners locked in very low fixed rates on their debt, so they’re not feeling the pain as much,” Mulberry said. “Renters, however, did not have that opportunity.”
With rents up more than 30% nationwide between 2019 and 2023 and grocery costs rising 25% in the same period, renters who didn’t lock in low rates and are facing rental prices outpacing wage growth are experiencing the most stress in their monthly budgets, Mulberry said.
For now, the most important takeaway from the latest earnings reports is that “there was no new development this quarter in terms of asset quality,” Narron said. In fact, strong revenues, profits, and resilient net interest income indicate a still-healthy banking sector.
“There’s some strength in the banking sector that may not have been entirely expected, but it’s certainly reassuring to see that the structures of the financial system remain strong and sound,” Mulberry said. “However, we are monitoring closely, as prolonged high interest rates will continue to cause stress.”