As interest rates reach more than two-decade highs and inflation continues to affect consumers, major banks are preparing for increased risks associated with 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 represent the funds that banks allocate to cover potential credit risk losses, including bad debts and delinquent loans, especially in sectors like commercial real estate (CRE).
JPMorgan set aside $3.05 billion for credit losses, while Bank of America allocated $1.5 billion. Citigroup’s allowance for credit losses surged to $21.8 billion by the end of the quarter, more than tripling its reserves from the prior quarter. Wells Fargo’s provisions amounted to $1.24 billion.
These increased provisions indicate that banks are bracing for a more challenging financial landscape, where both secured and unsecured loans could lead to greater losses. According to a recent analysis by the New York Fed, Americans now owe a collective $17.7 trillion in consumer, student, and mortgage loans.
Credit card issuance and delinquency rates are also on the rise as many consumers deplete their pandemic savings and increasingly rely on credit. Credit card balances hit $1.02 trillion in the first quarter of this year, marking the second consecutive quarter that total balances exceeded the $1 trillion mark, according to TransUnion. The position of CRE remains tenuous as well.
“We are still recovering from the COVID era, and the health of the consumer largely depended on the stimulus provided during that time,” said Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, challenges for banks are expected to surface in the upcoming months. Mark Narron, a senior director at Fitch Ratings’ Financial Institutions Group, explained that quarterly provisions do not necessarily reflect recent credit quality but are more an indication of banks’ expectations for the future.
He noted a significant shift in the banking industry, moving from a model that raised provisions after loans began to fail, to one where macroeconomic forecasts primarily influence provisioning.
In the short term, banks anticipate slowing economic growth, a rise in unemployment, and potentially two interest rate cuts later this year, which may lead to increased delinquencies and defaults as the year ends.
Citi CFO Mark Mason commented that the warning signs are particularly pronounced among lower-income consumers, whose savings have dwindled since the pandemic.
“While we see overall resilience in the U.S. consumer, there is a noticeable divergence in performance based on income and credit scores,” Mason stated. Only the highest-income quartile has maintained more savings since 2019, with those in the over-740 FICO score range driving spending growth and high payment rates. In contrast, those in lower FICO bands are experiencing more significant declines in payment rates and are borrowing more due to the impacts of high inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5% as it awaits stabilization in inflation measures toward its 2% target before implementing anticipated rate cuts.
Despite preparations for broader defaults later this year, defaults haven’t yet risen to levels indicating a consumer crisis, according to Mulberry. He is particularly interested in the difference between homeowners and renters during the pandemic.
“Interest rates have risen significantly since then, but homeowners locked in very low fixed rates, so they aren’t feeling the strain like renters are,” said Mulberry. Renters, facing over 30% increases in rental costs between 2019 and 2023 and a 25% rise in grocery prices during the same period, are experiencing notable stress in their budgets.
For now, the latest earnings reports reveal no significant changes in asset quality. The strong revenues, profits, and resilient net interest income suggest a still-healthy banking sector.
“There’s some strength in the banking sector that may not have been entirely expected, providing reassurance that the financial system remains robust at this moment,” Mulberry concluded. “However, we remain vigilant; prolonged high interest rates will inevitably create more pressure.”