With interest rates reaching levels not seen in over two decades and inflation putting pressure on consumers, major banks are bracing for increased risks linked to their lending activities.
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 set aside by financial institutions to cover potential losses from credit risks, including delinquent loans and bad debt, particularly in areas like commercial real estate (CRE).
JPMorgan allocated $3.05 billion for credit losses 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, reflecting a threefold increase from the prior quarter, while Wells Fargo established provisions of $1.24 billion.
These increased reserves indicate that banks are preparing for a riskier lending landscape, where both secured and unsecured loans could result in greater losses. A recent study by the New York Fed highlighted that U.S. households owe a total of $17.7 trillion in consumer loans, student loans, and mortgages.
The issuance of credit cards and the rise in delinquency rates are also escalating as people deplete their pandemic-era savings and increasingly depend on credit. According to TransUnion, credit card balances hit $1.02 trillion in the first quarter of this year, marking the second consecutive quarter that totals exceeded the trillion-dollar mark. Additionally, the commercial real estate sector remains vulnerable.
“We’re still emerging from the effects of COVID, especially regarding banking and consumer health, largely due to the stimulus funding that was provided,” explained Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, the potential for challenges within banks may manifest in the coming months.
“The provisions reported each quarter don’t necessarily reflect credit quality from the past three months, but rather what banks anticipate will happen in the future,” commented Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
“Interestingly, we have transitioned from a system where an increase in bad loans led to higher provisions to one where broader economic forecasts predominantly influence provisioning,” he added.
In the short term, banks expect to see slower economic growth, an uptick in the unemployment rate, and anticipated interest rate cuts later this year in September and December, which could result in increased delinquencies and defaults by year-end.
Citi’s chief financial officer Mark Mason pointed out that these troubling signs are particularly prevalent among lower-income consumers, who have seen their savings decrease significantly since the pandemic began.
“While the overall U.S. consumer remains resilient, we are witnessing a divergence in performance and behavior across different income and credit score demographics,” Mason stated in a recent analyst call.
Mason further explained, “Only the highest income quartile has maintained more savings since early 2019, with customers scoring over 740 on the FICO scale fueling spending growth and high payment rates. In contrast, those with lower FICO scores are experiencing sharper declines in payment rates and are increasing their borrowing in response to high inflation and interest rates.”
The Federal Reserve has kept interest rates at a 23-year peak of 5.25-5.5%, pausing to await stabilization in inflation toward its 2% target before proceeding with expected rate cuts.
Despite banks preparing for potential defaults, current data does not indicate an imminent consumer crisis, according to Mulberry. He is particularly focused on the differences between homeowners and renters during the pandemic.
“While rates have indeed risen significantly, homeowners secured low fixed rates on their debts and are largely insulated from the pain caused by current conditions,” Mulberry noted, adding, “Renters during the same period missed that opportunity.”
In recent years, rents have surged by over 30% nationwide, while grocery costs have risen by 25% from 2019 to 2023. Renters without locked-in low rates are facing severe budget constraints as rental prices have outpaced wage growth.
For now, the key takeaway from the latest earnings reports is that there are no new issues regarding asset quality. In fact, strong revenues, profits, and persistent net interest income signal a robust banking environment.
“There’s a resilience in the banking sector that may not have been entirely anticipated, yet it is a relief to acknowledge that the foundational structures of our financial system remain robust,” Mulberry concluded. “However, we are monitoring the situation closely, as prolonged high interest rates could lead to more strain.”