As interest rates remain at their highest levels in over two decades and inflation continues to put pressure on consumers, major banks are gearing up to tackle greater risks associated with their lending practices.
During the second quarter, leading financial institutions such as JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo increased their provisions for credit losses compared to the previous quarter. These provisions represent the funds set aside by banks to cover potential losses related to credit risks, which include issues like bad debt and loans, particularly in the commercial real estate sector.
JPMorgan set aside $3.05 billion for credit losses in the second quarter, while Bank of America allocated $1.5 billion. Citigroup’s credit loss allowance at the end of the quarter was $21.8 billion, more than tripling its previous quarter’s build, and Wells Fargo reserved $1.24 billion.
This increase in provisions signifies that banks are preparing for a more challenging lending landscape, as both secured and unsecured loans could lead to greater losses for some of the largest banks in the United States. A recent report from the New York Federal Reserve highlighted that American households currently owe a combined total of $17.7 trillion in consumer loans, student loans, and mortgages.
The issuance of credit cards, along with rising delinquency rates, is also becoming more prevalent as consumers deplete the savings they accumulated during the pandemic and increasingly depend on credit. Credit card balances reached $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where total credit card balances surpassed the trillion-dollar mark, according to TransUnion. Additionally, the commercial real estate sector remains vulnerable.
“We are still emerging from the COVID era, especially regarding banking and consumer health, largely due to the stimulus provided to consumers,” stated Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, experts suggest that any challenges for banks are likely to materialize in the coming months.
“The provisions recorded in any given quarter do not necessarily reflect the credit quality over the past three months; they indicate what banks anticipate for the future,” explained Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
Narron noted a shift in how provisions are determined, moving from a historical model where deteriorating loans triggered provisions, to a model where macroeconomic forecasts heavily influence provisioning decisions. Banks foresee slowing economic growth, increasing unemployment rates, and two expected interest rate cuts later this year, which could lead to a rise in delinquencies and defaults by the end of the year.
Citi’s Chief Financial Officer Mark Mason highlighted that the potential issues largely affect lower-income consumers, who have seen their savings sharply decline since the pandemic began.
“While the overall U.S. consumer appears resilient, we observe varying performances across different income segments,” Mason stated in a recent analyst call. “Only the highest income quartile has managed to maintain more savings than they had at the start of 2019, with those having a credit score above 740 driving spending growth and high payment rates, whereas consumers with lower credit scores are experiencing significant drops in payment rates while increasing their borrowing, largely due to the impacts of inflation and rising interest rates.”
The Federal Reserve continues to maintain interest rates within a range of 5.25-5.5%, the highest in 23 years, as it awaits stabilization in inflation measures toward the central bank’s 2% goal before implementing anticipated rate cuts.
Despite banks bracing for increased defaults later this year, Mulberry believes defaults are not rising at a rate indicative of an impending consumer crisis. He emphasizes the difference in impact between homeowners and renters during the pandemic.
“Homeowners have locked in very low fixed rates on their debt, so they are largely insulated from the pain of rising rates,” Mulberry noted. “Conversely, renters who missed that opportunity face significant challenges, with rents increasing over 30% nationwide from 2019 to 2023 and grocery prices up 25%, while wages have not kept pace.”
Nevertheless, the latest earnings reveal that “there was nothing new this quarter regarding asset quality,” according to Narron. Strong revenues, profits, and robust net interest income signals a still-healthy banking sector.
“There are positive signs in the banking sector that may not have been entirely unexpected, but it is reassuring to see the financial system’s structure remain strong and sound during this time,” Mulberry concluded. “However, we will monitor the situation closely, as prolonged high-interest rates will lead to increased stress.”