As interest rates reach levels not seen in over twenty years and inflation continues to impact consumers, major banks are bracing for heightened risks in 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 funds that banks allocate to cover potential losses from credit risks, including overdue debts and troubled loans, like those related to commercial real estate.
JPMorgan set aside $3.05 billion for credit losses in the second quarter, while Bank of America recorded $1.5 billion. Citigroup’s allowance for credit losses surged to $21.8 billion at the end of the quarter, marking a tripling of its reserves from the previous quarter. Wells Fargo reported provisions of $1.24 billion.
These increased provisions indicate that banks are preparing for a riskier lending environment, where both secured and unsecured loans could lead to larger losses for these institutions. A recent study by the New York Fed revealed that U.S. households collectively owe $17.7 trillion in consumer loans, student loans, and mortgages.
Credit card issuance and delinquency rates are also rising as consumers deplete their pandemic savings and increasingly rely on credit. Credit card balances reached $1.02 trillion in the first quarter of this year, with this being the second consecutive quarter where total balances surpassed the trillion-dollar mark, according to TransUnion. The commercial real estate sector continues to be vulnerable as well.
“We’re still recovering from the COVID era, particularly in terms of banking and consumer health, largely due to the stimulus efforts made during that time,” explained Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, any challenges for banks are expected to emerge in the coming months. Mark Narron, a senior director at Fitch Ratings, noted, “The provisions observed in any given quarter do not necessarily reflect the credit quality from the past three months, but rather what banks anticipate for the future.”
He added that the industry has shifted from a reliance on historical delinquency rates to a model driven by macroeconomic forecasts for provisioning.
In the short term, banks anticipate slowed economic growth, rising unemployment rates, and potential interest rate cuts later this year, which could lead to increased delinquencies and defaults by year’s end.
Citi’s Chief Financial Officer, Mark Mason, highlighted that these warning signs appear to be largely affecting lower-income consumers, who have experienced significant declines in their savings since the pandemic.
“While we observe a generally resilient U.S. consumer, we also see notable differences in performance across various income levels and credit scores,” Mason stated in a recent analyst call.
Mason noted that only the top income quartile has more savings than they did in early 2019, with high-credit-score customers driving spending growth and maintaining high payment rates. Conversely, lower-income consumers are experiencing sharper declines in payment rates and are borrowing more, as they are more adversely affected by rising inflation and interest rates.
The Federal Reserve has maintained interest rates at a peak of 5.25-5.5% as it waits for inflation to stabilize near its target of 2% before executing anticipated rate cuts.
Despite banks’ preparations for an uptick in defaults later this year, Mulberry points out that defaults are currently not rising at a level indicative of a consumer crisis. He is monitoring the distinction between individuals who owned homes during the pandemic versus those who rented.
“While interest rates have significantly increased since then, homeowners secured low fixed rates on their debts and therefore are not feeling the strain as acutely,” Mulberry explained. “Renters, however, missed out on that opportunity and are now facing challenges.”
With rental rates increasing over 30% from 2019 to 2023 and grocery prices rising by 25%, renters are under financial pressure as their budgets struggle against rising costs that have outpaced wage growth, according to Mulberry.
Currently, the most notable takeaway from recent earnings reports is that asset quality remains stable, as highlighted by Narron. Strong revenues, profits, and solid net interest income point towards a healthy banking sector.
“There is strength in the banking sector that may not have been entirely unexpected, but it is reassuring to see that the financial system remains robust and sound at this moment,” Mulberry stated. “However, we are watching closely; the longer interest rates stay at high levels, the more stress it will create.”