With interest rates reaching their highest levels in over two decades and inflation pressing consumers, major banks are bracing for increased lending risks.
Jerome Powell’s keynote address at the Jackson Hole Economic Symposium on Friday is anticipated to influence market movements significantly, and investors are closely monitoring the situation.
In the second quarter, leading financial institutions such as JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo reported an increase in their credit loss provisions compared to the previous quarter. These provisions represent the funds that banks allocate to cover potential losses from credit risks, including defaults and problematic loans, particularly in commercial real estate.
JPMorgan set aside $3.05 billion for credit losses in the second quarter, while Bank of America allocated $1.5 billion. Citi’s credit loss allowance reached $21.8 billion by the end of the quarter, more than tripling its reserves from the prior period. Wells Fargo recorded provisions of $1.24 billion.
This buildup of reserves indicates that banks are preparing for a more challenging economic landscape, where both secured and unsecured loans might lead to greater losses. A recent analysis from the New York Fed revealed that American households are collectively $17.7 trillion in debt from various loans, including consumer, student, and mortgage debts.
Credit card usage and delinquency rates are also increasing, as individuals exhaust their pandemic-era savings 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 balances exceeded the trillion-dollar milestone, according to TransUnion. Additionally, the commercial real estate sector is facing significant challenges.
“We’re still emerging from the COVID period, primarily when it comes to banking and consumer health, largely due to the stimulus provided to households,” stated Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, the banks expect their challenges to materialize in the forthcoming months.
“The provisions shown for any quarter do not necessarily represent credit quality over the past three months; they indicate banks’ expectations of future developments,” explained Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
“The situation has evolved from a historical perspective where a spike in bad loans would lead to an increase in provisions, to a model primarily driven by macroeconomic forecasts,” he noted.
In the short term, banks anticipate slowing economic growth, a rise in unemployment, and two potential interest rate cuts later this year, which could result in increased delinquencies and defaults as the year concludes.
Citi’s chief financial officer Mark Mason highlighted that these concerning indicators primarily affect lower-income consumers, who have seen their savings decline since the pandemic began.
“While we observe a generally resilient U.S. consumer, there’s a widening performance gap based on credit scores and income levels,” Mason remarked in a recent analyst call.
He added, “When we look at our consumer clients, only those in the highest income quartile have more savings than they did at the start of 2019, and it is our customers with FICO scores above 740 driving spending growth and maintaining high payment rates. In contrast, those with lower FICO scores are experiencing significant declines in payment rates and are borrowing more due to the impacts of high inflation and interest rates.”
The Federal Reserve has maintained interest rates at a peak of 5.25% to 5.5%, awaiting inflation to stabilize towards the central bank’s target of 2% before proceeding with expected rate cuts.
Despite banks gearing up for potential defaults later in the year, current default rates do not indicate an impending consumer crisis, according to Mulberry. He is particularly analyzing the differences between homeowners and renters from the pandemic period.
“While interest rates have surged since then, homeowners secured low fixed-rate debts and are largely unaffected, whereas renters missed out on that opportunity,” Mulberry said. “With rents rising over 30% nationally from 2019 to 2023 and grocery prices increasing by 25% in that same timeframe, renters who didn’t benefit from low rates are facing significant strain on their budgets.”
Nevertheless, the key takeaway from the most recent earnings reports is that “the quarter didn’t reveal any new issues in asset quality,” according to Narron. Strong revenues, profits, and stable net interest income are reassuring signs of a robust banking sector.
“There is an underlying strength in the banking system that, while not entirely surprising, is a relief to recognize,” Mulberry concluded. “The financial system’s structures remain strong and sound, but we must continue to monitor the situation closely, as prolonged high interest rates will inevitably create more stress.”