With interest rates at their highest level in over 20 years and inflation putting pressure on consumers, major banks are gearing up to confront increased risks associated with their lending operations.
In the second quarter, leading banks such as JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo increased their provisions for credit losses from the previous quarter. These provisions are funds reserved by financial institutions to cover potential losses from credit risk, which includes delinquent, bad debt, and various types of lending, particularly commercial real estate (CRE) loans.
JPMorgan set aside $3.05 billion for credit losses in the second quarter; Bank of America allocated $1.5 billion; Citigroup’s allowance for credit losses reached $21.8 billion—more than tripling its reserve from the prior quarter; and Wells Fargo had provisions of $1.24 billion.
These reserves indicate that banks are preparing for a riskier economic landscape, where both secured and unsecured loans may result in larger losses for some of the nation’s largest financial institutions. A recent report from the New York Fed noted that U.S. households now have a combined debt of $17.7 trillion encompassing consumer loans, student debt, and mortgages.
Credit card issuance is also rising, along with delinquency rates, as consumers exhaust their pandemic-era savings and increasingly rely on credit. In the first quarter of this year, credit card balances reached $1.02 trillion, marking the second consecutive quarter where total cardholder balances surpassed the trillion-dollar threshold, according to TransUnion. The commercial real estate sector is also facing significant challenges.
“We’re still emerging from the COVID era, and regarding banking and consumer strength, the impact of stimulus provided to consumers has been significant,” observed Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, potential troubles for banks may emerge in the coming months. “The provisions reported in any quarter do not necessarily reflect credit quality over the last three months; rather, they indicate what banks forecast may happen in the future,” stated Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
He further explained that the approach has shifted from a model where provisions increased as loans began to default, to one where macroeconomic forecasts largely determine provisioning strategies.
In the short term, banks are expecting a slowdown in economic growth, an uptick in unemployment, and two interest rate cuts anticipated later this year in September and December, which might lead to more delinquencies and defaults as the year comes to an end.
Citigroup’s chief financial officer, Mark Mason, pointed out that the early warning signs tend to be most pronounced among lower-income consumers, who have seen their savings deplete since the pandemic began.
“While the overall U.S. consumer remains resilient, there is a noticeable disparity in performance and behavior across different income levels and credit scores,” Mason remarked in an analyst call earlier this month.
He explained that only the top income quartile has maintained greater savings than at the end of 2019, with those in the higher FICO score bracket continuing to drive spending growth and uphold high payment rates. Conversely, lower FICO score customers are experiencing declines in payment rates and are borrowing more, as they are disproportionately affected by high inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high of 5.25% to 5.5%, awaiting stabilization of inflation metrics towards the central bank’s 2% target prior to implementing the anticipated rate cuts.
Despite banks preparing for an increase in defaults towards the end of the year, current default rates do not yet indicate a widespread consumer crisis, according to Mulberry. He is monitoring the distinctions between individuals who were homeowners during the pandemic compared to those who were renters.
“While rates have risen significantly since then, homeowners secured low fixed rates on their debt, so they are not feeling the financial strain as much,” Mulberry explained. “Renters, however, did not benefit from those conditions.”
With rental prices increasing by over 30% nationwide between 2019 and 2023, and grocery costs rising by 25%, renters unable to lock in lower rates are experiencing considerable stress within their budgets.
For now, the key takeaway from the latest earnings reports is that there were no significant developments regarding asset quality. In fact, robust revenues, profits, and stable net interest income point to a banking sector that remains in good health.
“There is strength in the banking sector that may not have been entirely unexpected, but it’s reassuring to confirm that the financial system’s foundations are still resilient as of now,” Mulberry affirmed. “Yet, we remain vigilant; the longer interest rates stay at elevated levels, the more strain they can impose.”