With interest rates reaching their highest levels in over two decades and inflation putting pressure on consumers, major banks are bracing for increased risks associated with their lending practices.
In the second quarter, four of the largest banks—JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo—increased their provisions for credit losses compared to the previous quarter. These provisions are reserves set aside to cover potential losses from credit risks, including bad debt and commercial real estate (CRE) loans.
JPMorgan allocated $3.05 billion for credit losses in the second quarter, while Bank of America set aside $1.5 billion. Citigroup reported an allowance for credit losses of $21.8 billion at the close of the quarter, which marked more than a tripling of its reserves from the prior quarter. Wells Fargo’s provisions amounted to $1.24 billion.
These provisions indicate that the banks are preparing for a more challenging economic environment, where both secured and unsecured loans may lead to larger losses for these financial institutions. A recent study by the New York Federal Reserve revealed that American households are collectively burdened with $17.7 trillion in debt, encompassing consumer loans, student loans, and mortgages.
Credit card issuance, along with rising delinquency rates, is also becoming more prominent as consumers deplete their pandemic-era savings and increasingly depend on credit. Credit card balances hit $1.02 trillion in the first quarter, marking the second consecutive quarter where totals have surpassed the trillion-dollar mark, according to TransUnion. Meanwhile, the CRE sector remains vulnerable.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, commented, “We’re still emerging from this COVID era, where the health of the consumer and the banking sector was supported by stimulus efforts.”
However, challenges for the banks are anticipated in the coming months. Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, noted, “The provisions reflected at any point in time do not necessarily represent recent credit quality; rather, they indicate what banks foresee occurring in the future.”
Narron explained that the current model has shifted from one where increasing loan defaults lead to higher provisions, to one where broader economic forecasts primarily dictate these reserves. In the short term, banks are anticipating slower economic growth, elevated unemployment rates, and two interest rate cuts scheduled for September and December. This scenario could lead to a rise in delinquencies and defaults by year-end.
Citi’s chief financial officer, Mark Mason, highlighted troubling trends, particularly among lower-income consumers who have seen their savings diminish since the pandemic. He mentioned, “While the overall U.S. consumer remains resilient, we observe a divergence in performance across income groups and credit scores.”
Mason noted that only the top income quartile has maintained more savings than they did in early 2019, and it is primarily those customers with FICO scores above 740 who are contributing to spending growth and sustaining high payment rates. Conversely, consumers in lower FICO bands are experiencing significant declines in payment rates and are increasing borrowing due to the stresses of high inflation and rising interest rates.
The Federal Reserve has maintained interest rates at a 23-year peak of 5.25-5.5% while awaiting a stabilization in inflation metrics to achieve its target rate of 2% before implementing expected rate cuts.
Despite banks readying themselves for potential defaults later in the year, Mulberry indicated that default rates are not suggesting an imminent consumer crisis. He is particularly observing the dynamics between homeowners and renters post-pandemic.
“Homeowners, having locked in low fixed rates, are less impacted by rising rates. In contrast, renters, who missed that opportunity, are facing increased stress,” Mulberry said, noting that nationwide rents have surged over 30% from 2019 to 2023, coupled with a 25% rise in grocery costs during the same period.
Overall, Narron pointed out that the recent earnings results revealed no new developments concerning asset quality. Strong revenues, profits, and resilient net interest income are positive signs for the banking sector’s health.
Mulberry concluded, “There remains some strength within the banking sector, which is reassuring, but we are vigilant—prolonged high interest rates could lead to increased stress.”