With interest rates at their highest levels in over two decades and persistent inflation affecting consumers, major banks are bracing for increased risks associated with their lending practices.
In the second quarter, key financial institutions, including JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo, heightened their provisions for credit losses compared to the previous quarter. These provisions are funds set aside to cover potential losses from credit risks, which encompass bad debts and commercial real estate loans.
JPMorgan allocated $3.05 billion for credit losses during the second quarter, while Bank of America reported $1.5 billion. Citigroup’s allowance for credit losses reached $21.8 billion, more than tripling its reserve build from the previous quarter, and Wells Fargo set aside $1.24 billion.
This increase in reserves reflects the banks’ anticipation of a more challenging lending environment, where both secured and unsecured loans could lead to greater losses. A recent report from the New York Fed highlighted that American households collectively owe $17.7 trillion in consumer, student, and mortgage loans.
Additionally, credit card issuance and delinquency rates are surging, as individuals deplete their pandemic savings and increasingly rely on credit. By the first quarter of this year, credit card balances surpassed $1 trillion for the second consecutive quarter, according to TransUnion. Moreover, commercial real estate remains particularly vulnerable.
According to Brian Mulberry, a client portfolio manager at Zacks Investment Management, the financial industry is still recovering from COVID-19, largely due to government stimulus that supported consumers.
However, market analysts caution that any banking issues may arise in the coming months. Mark Narron, a senior director at Fitch Ratings, explained, “Provisions made in a quarter do not necessarily reflect recent credit quality but rather banks’ projections for the future.”
He pointed out that the banking system has shifted from a reactive stance, where provisions increase only after loans perform poorly, to a proactive approach driven by macroeconomic forecasts.
Looking ahead, banks are predicting slower economic growth, a potential rise in unemployment, and two expected interest rate cuts in September and December. These changes could lead to increased delinquency and default rates before the year concludes.
Mark Mason, Citi’s chief financial officer, emphasized that concerns are particularly focused on lower-income consumers, who have depleting savings post-pandemic. While the overall U.S. consumer remains resilient, data indicates a clear divide in financial performance based on income levels and credit scores.
Currently, only the highest income quartile has maintained higher savings compared to early 2019, while consumers with credit scores above 740 are primarily responsible for increased spending and low payment rates. In contrast, those with lower credit scores are facing greater financial strain, often borrowing more due to the heightened pressures of inflation and interest rates.
As the Federal Reserve maintains interest rates between 5.25% to 5.5%—the highest in 23 years—waiting for inflation to stabilize around its 2% target, banks remain cautious about the potential for increased defaults.
Nonetheless, while institutions are preparing for greater defaults in the latter part of the year, Mulberry noted that current default rates do not indicate a consumer crisis. He is particularly observing the differences between homeowners and renters from the pandemic era.
Despite significant interest rate increases, homeowners locked in low fixed rates during that time, thus largely avoiding financial distress. Conversely, renters have faced over 30% hikes in rent since 2019 and a 25% rise in grocery costs, putting them under considerable financial strain as their expenses outpace wage growth.
Overall, analysts like Narron view the latest earnings reports as revealing no new concerns regarding asset quality. Strong revenues, profits, and robust net interest income suggest that the banking sector remains fundamentally healthy.
Mulberry remarked on the resilience observed, stating, “While some strength in the banking sector might not have been unexpected, it is reassuring to confirm that the structures of the financial system are sound. However, we remain vigilant as prolonged high-interest rates could induce stress.”