As interest rates reach their highest levels in over two decades and inflation continues to affect consumers, major banks are bracing for increased risks associated with 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 are funds set aside by banks to cover potential losses due to credit risks, including defaults on delinquent debts and commercial real estate loans.
JPMorgan allocated $3.05 billion for credit losses during the second quarter; Bank of America reported $1.5 billion; Citi’s allowance for credit losses swelled to $21.8 billion, marking a threefold increase from the prior quarter; and Wells Fargo’s provisions reached $1.24 billion.
These increased reserves indicate that banks are preparing for a potentially riskier financial landscape, where both secured and unsecured loans might incur larger losses. A recent study by the New York Fed revealed that American households owe a staggering $17.7 trillion in consumer loans, student loans, and mortgages.
Furthermore, credit card issuance and delinquency rates are also rising as consumers exhaust their pandemic-related savings and increasingly depend on credit. The total credit card balances reached $1.02 trillion in the first quarter, marking the second consecutive quarter where total balances surpassed the trillion-dollar threshold, according to TransUnion. The commercial real estate sector also remains vulnerable.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, commented that the banking landscape is still recovering from the COVID-19 era, heavily influenced by the consumer stimulus deployed during that time.
It’s important to note that the credit loss provisions reflect banks’ expectations about the future rather than the recent credit quality. Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, explained that there has been a shift from reactive provisioning based on loan performance to proactive measures driven by macroeconomic forecasts.
Banks anticipate slowing economic growth, an increased unemployment rate, and two potential interest rate cuts later this year, which could lead to more delinquencies and defaults as 2023 concludes.
Citi’s Chief Financial Officer, Mark Mason, highlighted concerning trends among lower-income consumers, whose savings have significantly diminished since the pandemic began.
While the overall U.S. consumer is exhibiting resilience, there’s a noticeable disparity in performance based on income and credit scores. Mason pointed out that only the top income bracket has managed to increase their savings since early 2019, with high FICO score customers contributing to spending growth and maintaining strong payment rates. In contrast, those in lower FICO brackets have seen their payment rates decline and are borrowing more due to the adverse effects of rising inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high between 5.25% and 5.5%, awaiting a stabilization of inflation measures around its 2% target before proceeding with anticipated rate cuts.
Despite banks preparing for potential defaults in the latter half of the year, the current rate of defaults does not suggest an imminent consumer crisis, according to Mulberry. He is closely observing the differences between homeowners and renters during the pandemic.
While interest rates have surged, homeowners who locked in low fixed rates during that time are not feeling the same financial strain. Conversely, renters, who did not benefit from these low rates, face challenges as rents have risen over 30% from 2019 to 2023, and grocery costs have climbed 25% in the same period, resulting in more significant budgetary stress.
Overall, the latest earnings reports indicate no major changes in asset quality, according to Narron. Strong revenues, profits, and healthy net interest income are encouraging signs for the banking sector.
Mulberry noted that the strength of the banking system remains resilient, but vigilance is essential as sustained high interest rates could lead to increased financial stress.