As interest rates reach their highest levels in over two decades and inflation continues to strain consumers, major banks are preparing to face increased risks from their lending activities.
In the second quarter, large financial institutions including JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo increased their provisions for credit losses compared to the previous quarter. These provisions represent the funds that banks allocate to cover potential losses from credit risk, which includes delinquent debts and problematic loans, particularly in the commercial real estate sector.
JPMorgan set aside $3.05 billion for credit losses in the second quarter, while Bank of America allocated $1.5 billion. Citigroup’s allowance for credit losses rose to $21.8 billion by the end of the quarter, more than tripling its previous reserve, and Wells Fargo reported provisions of $1.24 billion.
These adjustments indicate that banks are bracing for a riskier lending environment where both secured and unsecured loans could lead to greater losses. A recent report from the New York Fed revealed that U.S. consumers have accumulated a collective debt of $17.7 trillion in the form of consumer loans, student loans, and mortgages.
Additionally, there has been an uptick in credit card issuance and delinquency rates as individuals deplete their pandemic savings and increasingly rely on credit. Credit card debt reached $1.02 trillion in the first quarter of this year, marking the second consecutive quarter that overall card balances surpassed the trillion-dollar threshold, according to TransUnion. The commercial real estate sector remains vulnerable as well.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, noted that the banking sector is still grappling with the effects of the COVID-19 pandemic, primarily due to the consumer stimulus packages that were introduced.
However, the challenges for banks may become apparent in the coming months. Mark Narron, a senior director at Fitch Ratings’ Financial Institutions Group, explained that the provisions banks report each quarter do not necessarily reflect their credit quality over the past three months, but rather are based on anticipated future conditions.
Narron further highlighted a shift from a system where provisions increased after loans began to default to one where macroeconomic forecasts significantly influence these provisions. Currently, banks are projecting a slowdown in economic growth, an increase in unemployment rates, and potential interest rate cuts by September and December, which could lead to a rise in delinquencies and defaults as the year ends.
Citi CFO Mark Mason pointed out that the emerging warning signs are particularly pronounced among lower-income consumers who have seen their savings diminish since the pandemic began. He mentioned that while the overall consumer market remains resilient, there is a noticeable disparity in financial behavior across different wealth and credit score brackets.
“Only the highest income quartile has more savings than at the start of 2019,” Mason remarked, noting that it is primarily customers with FICO scores above 740 who are driving spending increases and maintaining consistent payment rates. In contrast, those in lower FICO categories are experiencing significant declines in payment rates and are borrowing more due to the pressures of rising inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5% and is waiting for inflation to stabilize toward its 2% target before implementing anticipated rate cuts.
Although banks are preparing for a potential increase in defaults in the latter half of the year, currently, defaults have not risen to levels indicating a consumer crisis, according to Mulberry. He observes a differentiation between those who owned homes during the pandemic and those who rented.
Despite significant rate increases, homeowners who secured low fixed-rate mortgages are largely unaffected by rising costs. Conversely, renters have faced over a 30% increase in rents from 2019 to 2023, with grocery prices also up by 25% during the same period. This disparity means that renters, lacking the advantage of fixed-rate loans, are experiencing greater financial strain.
At this point, financial experts note that the latest earnings reports reveal stability in asset quality. Strong revenues, profits, and resilient net interest income are positive indicators of the banking sector’s ongoing health.
Mulberry expressed cautious optimism about the banking sector, saying, “There’s some strength in the banking sector that I don’t know was totally unexpected, but I think it’s certainly a relief to say that the structures of the financial system are still very strong and sound at this point.” He added that ongoing high interest rates could increase stress in the sector over time.