With interest rates at their highest levels in over 20 years and inflation putting pressure on consumers, major banks are bracing for increased risks associated with their lending practices.
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 set aside to mitigate potential losses from credit risk, including overdue or defaulted debts and loans, such as commercial real estate lending.
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 by the end of the quarter, more than triple its reserve build from the previous quarter. Wells Fargo’s provisions stood at $1.24 billion.
These increased reserves reflect banks’ preparations for a more challenging financial landscape, where both secured and unsecured loans could lead to greater losses for these major institutions. According to a recent analysis from the New York Fed, U.S. households owe a total of $17.7 trillion in consumer loans, student loans, and mortgages.
Credit card issuance and delinquency rates are also climbing as consumers deplete their pandemic-era savings and increasingly rely on credit. Credit card balances hit $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where the overall total surpassed the trillion-dollar threshold, according to TransUnion. Additionally, commercial real estate remains in a vulnerable state.
“We’re still emerging from the COVID era, particularly in the realm of banking and consumer health, driven largely by government stimulus directed at consumers,” remarked Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, challenges for banks are anticipated in the coming months.
“The provisions recorded in any quarter do not necessarily reflect the credit quality from the past three months; rather, they indicate what banks expect to occur in the future,” explained Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
“This is somewhat intriguing, as we have shifted from a system where the emergence of bad loans prompted increases in provisions, to one where macroeconomic forecasts predominantly inform provisioning strategies,” he added.
In the short term, banks are forecasting a slowdown in economic growth, a rise in the unemployment rate, and expectations of interest rate cuts in September and December. This could lead to an increase in delinquencies and defaults by the end of the year.
Citi’s Chief Financial Officer, Mark Mason, pointed out that these warning signs seem to be particularly evident among lower-income consumers, who have seen their savings decline since the pandemic began.
“While we observe an overall resilient U.S. consumer, there is a noticeable disparity in performance and behavior across different income levels and credit scores,” Mason stated during a recent call with analysts. “Only the highest-income quartile has more savings than at the start of 2019, while customers with credit scores above 740 are driving spending growth and maintaining high payment rates. Conversely, customers with lower credit scores are experiencing significant drops in payment rates and are borrowing more amid high inflation and interest rates.”
The Federal Reserve has held interest rates at a 23-year peak of 5.25-5.5% as it awaits stabilization in inflation metrics toward the central bank’s 2% target before implementing the anticipated rate cuts.
Despite banks gearing up for increased defaults in the latter half of the year, default rates are not yet climbing to levels that suggest a consumer crisis, according to Mulberry. He is closely monitoring the differences between homeowners and renters from the pandemic period.
“Yes, rates have risen significantly since then, but homeowners secured very low fixed rates on their debts, so they are largely insulated from immediate pain,” Mulberry noted. “Renters, however, have missed out on that opportunity.”
With rents increasing over 30% nationwide from 2019 to 2023 and grocery prices rising by 25% during the same period, renters who did not secure low rates are feeling the most financial strain as their rental costs continue to outpace wage growth.
For now, the salient takeaway from the latest earnings report is that “there were no new developments this quarter regarding asset quality,” according to Narron. Notably, strong revenue, profits, and resilient net interest income indicate the health of the banking sector remains intact.
“There is some strength in the banking sector that, while not entirely unexpected, is certainly reassuring, affirming that the financial system’s structures are still robust at this time,” Mulberry added. “Nevertheless, we remain vigilant, as the longer interest rates stay elevated, the more stress this will induce.”