With interest rates reaching heights not seen in over 20 years and inflation pressuring consumers, major banks are bracing for increased risks associated with 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. Provisions are funds set aside by banks to cover potential losses from credit risks, including bad debts and various types of loans, such as commercial real estate loans.
JPMorgan prepared $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 soared to $21.8 billion by the end of the quarter, representing more than a threefold increase from the previous quarter, and Wells Fargo allocated $1.24 billion for this purpose.
These increased provisions signal that banks are anticipating a more challenging environment, where both secured and unsecured loans may lead to greater losses for these financial giants. A recent analysis by the New York Federal Reserve revealed that Americans collectively owe $17.7 trillion in consumer loans, student loans, and mortgages.
Credit card issuance—and the accompanying delinquency rates—are also on the rise, as many individuals are depleting their pandemic-era savings and turning to credit more frequently. Credit card balances hit $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where total cardholder balances surpassed the trillion-dollar threshold, according to TransUnion. Additionally, the commercial real estate sector remains vulnerable.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, noted that the banking sector’s current situation is a lingering consequence of the COVID-19 pandemic, largely fueled by the stimulus measures aimed at consumers.
However, any potential issues for the banks are likely to emerge in the coming months.
Mark Narron, a senior director at Fitch Ratings’ Financial Institutions Group, explained that the provisions reported in any given quarter do not necessarily reflect credit quality from the last three months, but rather represent banks’ expectations for the future.
He added, “It’s interesting to note that we’ve transitioned from a system where rising loan defaults would lead to increased provisions, to one where macroeconomic forecasts drive provisioning decisions.”
In the short term, banks predict slowing economic growth, higher unemployment rates, and anticipate two interest rate cuts later this year, potentially in September and December. This scenario could lead to a rise in delinquencies and defaults as the year ends.
Citi’s Chief Financial Officer Mark Mason observed that potential warning signs are mainly evident among lower-income consumers, who have seen their savings diminish since the pandemic began.
“While the overall U.S. consumer remains resilient, there is a noticeable divergence in spending behaviors based on credit scores and income levels,” Mason said during a recent analysts’ call.
He pointed out that only the highest-income group has accumulated more savings than they had at the start of 2019, with those above the 740 FICO score seeing growth in spending and maintaining high payment rates. In contrast, consumers with lower credit scores are experiencing significant declines in payment rates and are borrowing more, feeling the impact of elevated inflation and interest rates.
The Federal Reserve is maintaining interest rates at a two-decade high of 5.25-5.5%, awaiting stabilization in inflation metrics towards its 2% target before enacting expected rate cuts.
Despite banks anticipating increased defaults later in the year, current default rates do not show signs of a consumer crisis, Mulberry remarked. He is particularly interested in the contrast between homeowners during the pandemic and renters.
“While rates have indeed risen, homeowners secured very low fixed rates for their debt, so they aren’t feeling the pinch as much,” he said. “Renters, on the other hand, have not had that advantage.”
With rents increasing by over 30% nationwide from 2019 to 2023 and grocery prices rising by about 25% in the same period, renters—who did not benefit from low rates—are experiencing financial strain, according to Mulberry.
At this stage, the key takeaway from the recent earnings reports is that there was nothing particularly alarming regarding asset quality. Strong revenues, profits, and robust net interest income indicate that the banking sector remains healthy.
“There is some strength in the banking sector that may not have been entirely surprising, but it is reassuring to recognize that the financial system’s structure remains solid and sound at this time,” Mulberry concluded. “However, the longer the high interest rates persist, the more pressure it will place on the sector.”