With interest rates at their highest in over two decades and inflation impacting consumers, major banks are gearing up for increased risks stemming from their lending practices.
During 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 are funds that banks reserve to cover potential losses from credit risk, such as bad debts and defaults on loans, including commercial real estate (CRE) loans.
JPMorgan allocated $3.05 billion for credit loss provisions in the second quarter, while Bank of America set aside $1.5 billion. Citigroup’s credit loss reserves climbed to $21.8 billion—more than tripling the amount from the previous quarter—while Wells Fargo reported provisions of $1.24 billion.
These provisions indicate that banks are preparing for a riskier environment, as both secured and unsecured loans may lead to larger losses for some of the country’s largest financial institutions. A recent analysis by the New York Fed revealed that Americans are carrying a total of $17.7 trillion in debt, including consumer loans, student loans, and mortgages.
The issuance of credit cards and the associated delinquency rates are also on the rise, as pandemic-era savings dwindle and consumers increasingly turn to credit. TransUnion reported that total credit card balances hit $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where cardholder balances surpassed the trillion-dollar threshold. The situation for CRE remains uncertain.
“We’re still emerging from the COVID period, especially regarding banking and consumer health, largely due to the stimulus measures provided to consumers,” stated Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, any challenges for banks are anticipated to manifest in the coming months. “The provisions observed in any quarter do not necessarily reflect credit quality from the past three months; they indicate the banks’ expectations for future conditions,” explained Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
“We’ve shifted from a historical perspective where bad loans prompted higher provisions to a model where macroeconomic forecasts drive provisioning decisions,” he added.
In the short term, banks are expecting slower economic growth, an uptick in unemployment, and potential interest rate cuts in September and December, according to Narron. This could lead to increased delinquencies and defaults as the year ends.
Citi’s chief financial officer, Mark Mason, pointed out that these warnings seem particularly evident among lower-income consumers, who have seen their savings decline since the pandemic.
“While the overall U.S. consumer remains resilient, there is a noticeable divergence in performance and behavior across different FICO scores and income levels,” Mason noted during a recent call with analysts.
He added, “Among our consumer clients, only the highest income quartile has more savings than at the start of 2019, and it is these customers with FICO scores over 740 who are driving spending growth and maintaining high payment rates. In contrast, lower FICO score customers are experiencing significant declines in payment rates and increasing their borrowing, as they are more adversely affected by high inflation and interest rates.”
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5% while it awaits inflation metrics to trend toward its 2% target before proceeding with expected rate cuts.
Despite banks bracing for broader defaults later this year, current default rates do not yet indicate a consumer crisis, according to Mulberry. He is particularly noting the difference between those who owned homes during the pandemic and those who rented.
“Yes, interest rates have risen significantly, but homeowners locked in very low fixed rates, so they aren’t feeling the pain as much. Those who rented during that time did not have that advantage,” Mulberry said. “Rent prices have surged over 30% nationally between 2019 and 2023, while grocery costs have risen 25%. Renters, who could not secure low rates, are facing immense pressure in their budgets.”
For now, the key takeaway from the latest earnings reports is that “there wasn’t anything new this quarter regarding asset quality,” according to Narron. In fact, robust revenues, profits, and strong net interest income suggest that the banking sector remains healthy.
“There is some resilience in the banking sector that may not have been entirely unexpected, but it’s certainly reassuring to note that the financial system’s structures are still robust at this time,” Mulberry remarked. “However, we are closely monitoring the situation, as prolonged high-interest rates can increase stress on consumers.”