As interest rates reach their highest levels in over two decades and inflation continues to pressure consumers, major banks are bracing for increased risks associated with their lending operations.
In the second quarter of the year, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo increased their provisions for credit losses compared to the previous quarter. These provisions are funds set aside by financial institutions to cover potential losses arising from credit risk, which includes delinquent debts and loans such as those related to commercial real estate.
JPMorgan allocated $3.05 billion to its provision for credit losses in the second quarter, while Bank of America set aside $1.5 billion. Citigroup’s allowance for credit losses reached $21.8 billion at the end of the quarter, significantly surpassing its reserve build from the prior quarter. Wells Fargo provisioned $1.24 billion for credit losses.
These provisions indicate that banks are preparing for a potentially riskier landscape, where both secured and unsecured loans may result in larger losses for some of the largest financial institutions in the country. According to a recent analysis by the New York Federal Reserve, Americans collectively owe $17.7 trillion in consumer loans, student loans, and mortgages.
Furthermore, the issuance of credit cards and the associated delinquency rates are increasing as individuals deplete their savings accumulated during the pandemic and increasingly depend on credit. Credit card balances hit $1.02 trillion in the first quarter, marking the second consecutive quarter with total cardholder balances surpassing the trillion-dollar threshold, as reported by TransUnion. The commercial real estate sector also remains vulnerable.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, explained, “We’re still coming out of this COVID era, primarily in terms of the banking sector and consumer health, due to the stimulus deployed.”
However, any potential issues for the banks are likely to materialize in the coming months. Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, noted that the provisions reported each quarter indicate not only recent credit quality but also banks’ expectations of future developments.
“This marks a shift from the historical model, where deteriorating loans would lead to increased provisions, to a current model driven by macroeconomic forecasts,” he explained.
In the near future, banks anticipate slower economic growth, a rise in unemployment, and two expected interest rate cuts later this year, which could lead to increased delinquencies and defaults by year-end.
Citi’s Chief Financial Officer Mark Mason highlighted that warning signs seem concentrated among lower-income consumers, who have seen their savings diminish since the pandemic began.
“While we observe an overall resilient U.S. consumer base, a gap persists in performance and behavior across different income brackets and credit scores,” Mason noted in a recent call with analysts.
He further stated, “Only the highest income quartile has seen an increase in savings since early 2019, with those holding scores above 740 driving spending growth and maintaining high payment rates. Conversely, lower-score customers are experiencing sharp declines in payment rates and are borrowing more, significantly impacted by high inflation and interest rates.”
The Federal Reserve continues to maintain interest rates at a 23-year high range of 5.25-5.5% as it awaits stabilization in inflation towards the central bank’s 2% target before implementing anticipated rate cuts.
Despite banks preparing for an increase in defaults as the year progresses, current default rates do not indicate a widespread consumer crisis, according to Mulberry. He is particularly observing the distinction between homeowners during the pandemic and renters.
“While rates have surged significantly, homeowners secured low fixed rates on their mortgages, mitigating their financial stress,” he stated. “Renters missed that opportunity and face higher costs.”
With rent levels rising over 30% nationwide from 2019 to 2023 and grocery prices increasing by 25%, renters who didn’t lock in low rates are experiencing the most significant strain on their monthly budgets.
Overall, the latest earnings report suggests that there was no significant new deterioration in asset quality, according to Narron. Robust revenues, profits, and stable net interest income remain positive signs for the banking sector.
“There’s an underlying strength in the banking industry, which may not have been entirely unexpected but is reassuring. The foundations of the financial system appear to be robust at this moment,” Mulberry remarked, cautioning that prolonged high interest rates could induce more stress in the future.