With interest rates reaching their highest levels in over 20 years and inflation persistently impacting consumers, major banks are gearing up to tackle increased risks associated with their lending activities.
In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all increased their provisions for credit losses compared to the previous quarter. These provisions represent the funds that banks reserve to cover potential losses from credit risks, including overdue debts and lending, particularly in commercial real estate (CRE).
JPMorgan allocated $3.05 billion for credit loss provisions 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, marking more than a threefold increase from the previous quarter, and Wells Fargo had provisions of $1.24 billion.
These increased reserves indicate that banks are bracing for a more challenging environment, where both secured and unsecured loans might lead to larger losses for some of the largest financial institutions in the country. According to a recent analysis by the New York Federal Reserve, U.S. households carry a collective debt of $17.7 trillion, encompassing consumer loans, student loans, and mortgages.
The rise in credit card issuance and delinquency rates signals a growing reliance on credit as pandemic-era savings diminish. In the first quarter of this year, total credit card balances surpassed $1 trillion for the second consecutive quarter, as reported by TransUnion. Furthermore, the commercial real estate sector remains vulnerable.
“We’re still recovering from the COVID era, and it was largely driven by the stimulus directed toward consumers,” stated Brian Mulberry, a portfolio manager at Zacks Investment Management.
However, potential issues for banks are anticipated in the coming months. “The provisions reported in any given quarter do not necessarily reflect the credit quality for the preceding three months; they indicate what banks expect will happen in the future,” remarked Mark Narron, a senior director at Fitch Ratings.
He also noted that the trend has shifted from a system where rising loan defaults lead to increased provisions, to one where macroeconomic forecasts primarily determine provisioning.
In the near term, banks expect slower economic growth, a rise in unemployment, and two interest rate cuts later this year in September and December. This scenario could lead to more delinquencies and defaults by year-end.
Citi’s Chief Financial Officer Mark Mason highlighted that warning signs are particularly evident among lower-income consumers, who have depleted their savings since the pandemic began. “While the overall U.S. consumer remains resilient, there are noticeable differences in performance and behavior across income levels,” Mason noted in a recent analyst call.
He further explained that only the highest income quartile has maintained more savings compared to the beginning of 2019, with only high FICO score customers driving spending growth and sustaining high payment rates. Conversely, customers with lower FICO scores are experiencing a significant decline in payment rates and are borrowing more due to the dual pressures of high inflation and interest rates.
The Federal Reserve continues to maintain interest rates at a 23-year peak of 5.25-5.5%, awaiting stabilization in inflation towards its 2% target before considering any rate cuts.
Although banks are preparing for a potential rise in defaults later this year, Mulberry indicated that current default rates do not yet indicate a consumer crisis. He is particularly observing the differences between homeowners and renters since the pandemic began.
“Yes, interest rates have increased significantly since then, but homeowners secured very low fixed rates on their debt, so they aren’t feeling the pressure as much,” Mulberry explained. “In contrast, renters who didn’t lock in those low rates are facing rising rents and groceries, which have increased over 30% and 25% respectively from 2019 to 2023, without a corresponding rise in wages.”
For now, the main takeaway from the most recent earnings reports is that “nothing new emerged this quarter in terms of asset quality,” according to Narron. Strong revenues, profits, and healthy net interest income all suggest that the banking sector remains robust.
“There is some resilience in the banking sector that was perhaps not entirely unexpected, but it is reassuring to confirm that the structures of the financial system are still strong and sound at this moment,” Mulberry added. “However, we remain vigilant; the longer interest rates remain elevated, the more tension it will create.”