As interest rates reach levels not seen in over 20 years and inflation continues to impact consumers, major banks are preparing for increased risks linked to their lending practices.
In the second quarter of this year, 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 that financial institutions set aside to mitigate potential losses from credit risk, including delinquent accounts and problematic loans, particularly in commercial real estate.
JPMorgan allocated $3.05 billion to its credit loss provisions in the second quarter, while Bank of America set aside $1.5 billion. Citigroup’s credit loss allowance amounted to $21.8 billion at the quarter’s end, having more than tripled its reserves from the prior quarter, and Wells Fargo reported $1.24 billion in provisions.
These precautionary measures indicate that banks are bracing for a riskier financial environment, where both secured and unsecured loans could lead to larger losses. A recent analysis by the New York Federal Reserve revealed that Americans collectively owe $17.7 trillion in consumer, student, and mortgage loans.
The rise in credit card issuance and subsequent delinquency rates is notable as consumers deplete their pandemic-era savings and increasingly rely on credit. In the first quarter of this year, credit card balances surpassed $1 trillion for the second consecutive quarter, a record high according to TransUnion. Additionally, the commercial real estate sector remains vulnerable.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, commented, “We’re still coming out of this COVID era, and mainly when it comes to banking and the health of the consumer, it was all of the stimulus that was deployed to the consumer.”
Challenges for banks are expected to grow in the months ahead.
Mark Narron, a senior director at Fitch Ratings, noted, “The provisions that you see at any given quarter don’t necessarily reflect credit quality for the last three months; they reflect what banks expect to happen in the future.” He explained that the current economic climate has shifted from a model where poor loan performance drove increased provisions to one where macroeconomic forecasts primarily dictate them.
Banks are anticipating a slowdown in economic growth, higher unemployment rates, and potential interest rate cuts later this year. This projection may lead to an increase in delinquencies and defaults as the year progresses.
Citi’s chief financial officer, Mark Mason, pointed out that red flags seem to be more pronounced among lower-income consumers, who have seen their savings decrease since the pandemic started.
“While we continue to see an overall resilient U.S. consumer, we also continue to see a divergence in performance and behavior across FICO and income bands,” Mason stated during an analyst call. He revealed that only the highest income quartile has managed to retain more savings compared to early 2019, and it is primarily high-FICO score customers who are driving spending and maintaining strong payment rates. Conversely, those in the lower FICO ranges face declining payment rates and are borrowing more due to the impact of high inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5%, awaiting inflation metrics to stabilize towards the central bank’s target of 2% before implementing anticipated rate cuts.
Despite banks preparing for higher default rates later in the year, Mulberry does not see current default rates indicating a consumer crisis. He observes a split between homeowners and renters, noting that while interest rates have risen significantly, homeowners secured low fixed rates during the pandemic and are not feeling the financial strain as acutely as renters.
With rents having surged over 30% nationwide from 2019 to 2023 and grocery prices up 25%, renters facing escalating rent costs without the benefit of low-rate mortgages are experiencing the greatest financial pressure.
Ultimately, the recent earnings reports indicate “there was nothing new this quarter in terms of asset quality,” according to Narron. Strong revenues, profits, and resilient net interest income signify a still-healthy banking sector.
“There’s some strength in the banking sector that I don’t think was totally unexpected, but it’s certainly reassuring to see that the foundations of the financial system remain robust,” Mulberry concluded. “However, we are monitoring the situation closely, as prolonged high-interest rates only exacerbate stress.”