With interest rates reaching levels not seen in over 20 years and inflation continuing to challenge consumers, major banks are bracing themselves for increased risks associated with their lending operations.
In the second quarter, leading banks such as JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo raised their provisions for credit losses compared to the previous quarter. These provisions represent funds set aside by financial institutions to mitigate potential losses stemming from credit risks, including bad debt and commercial real estate (CRE) loans.
JPMorgan increased its provision for credit losses by $3.05 billion during the second quarter; Bank of America set aside $1.5 billion; Citigroup’s allowance reached $21.8 billion at the quarter’s end—significantly more than the previous quarter’s credit reserve build; and Wells Fargo recorded provisions of $1.24 billion.
These increased reserves indicate that banks are preparing for a more challenging economic environment, where both secured and unsecured loans could pose higher risks. An analysis by the New York Fed indicates that Americans currently owe a collective total of $17.7 trillion in consumer loans, student loans, and mortgages.
Additionally, the issuance of credit cards and subsequent delinquency rates are on the rise as consumers burn through their pandemic-era savings and turn increasingly to credit. Credit card balances climbed to $1.02 trillion in the first quarter of this year, marking the second consecutive quarter that overall cardholder balances surpassed the trillion-dollar threshold. The commercial real estate sector remains particularly vulnerable.
“We’re still emerging from the COVID period, particularly in terms of banking and consumer health, largely due to the stimulus provided to consumers,” expressed Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, the repercussions for banks may not manifest immediately.
“The provisions seen in any given quarter do not necessarily reflect the credit quality from the previous three months; they are based on what banks anticipate will occur in the future,” stated Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
“Interestingly, we have transitioned from a historical system where provisions increased in tandem with rising loan defaults to one where macroeconomic forecasts predominantly guide provisioning decisions,” he added.
Short-term projections from banks point toward a slowdown in economic growth, rising unemployment, and anticipated interest rate cuts later this year in September and December, which could result in increased delinquencies and defaults as the year comes to a close.
Citi’s chief financial officer, Mark Mason, noted that these warning signs predominantly affect lower-income consumers, who have seen a decline in savings since the pandemic.
“While the overall U.S. consumer remains resilient, we are witnessing a divergence in performance and behavior across different income levels,” he remarked during a call with analysts.
“Among our consumer clients, only the highest income quartile has managed to maintain more savings compared to early 2019, and it’s predominantly high FICO score customers who are driving spending growth and maintaining consistent payment rates,” he added. “Conversely, lower FICO band clientele are experiencing drops in payment rates and are borrowing more, heavily impacted by elevated inflation and interest rates.”
The Federal Reserve continues to keep interest rates at a 23-year high of 5.25-5.5%, pausing on interest rate cuts until inflation stabilizes towards the central bank’s 2% target.
Despite the banks preparing for an uptick in defaults later this year, Mulberry noted that the current default rate does not indicate a consumer crisis. He is particularly monitoring the distinction between homeowners and renters during the pandemic.
“While interest rates have significantly risen since that time, homeowners secured very low fixed rates on their debts and thus are not feeling significant financial pressure. In contrast, renters missed that opportunity,” Mulberry explained.
With rents soaring over 30% nationwide between 2019 and 2023, and grocery prices increasing by 25% during the same timeframe, renters—who have not benefitted from low fixed rates—are under heightened financial strain.
Nonetheless, the key takeaway from the latest earnings reports is that “there were no new developments this quarter regarding asset quality,” said Narron. Strong revenues, profits, and resilient net interest income are all positive signs for the wellbeing of the banking sector.
“There is some strength in the banking sector that might not have been entirely anticipated, but it’s reassuring to recognize that the foundations of the financial system remain robust,” Mulberry concluded. “However, the longer that interest rates remain elevated, the more stress it creates.”