As interest rates remain at their highest levels in over 20 years and inflation continues to pressure 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 funds set aside by financial institutions to cover potential losses from credit risks, such as defaults or bad debt, particularly in areas like commercial real estate loans.
JPMorgan allocated $3.05 billion for credit losses during the second quarter, while Bank of America set aside $1.5 billion. Citigroup’s allowance for credit losses reached $21.8 billion at the end of the quarter, significantly more than the previous quarter’s reserve build. Wells Fargo reported provisions totaling $1.24 billion.
These increased reserves indicate that banks are preparing for a more challenging lending environment, where both secured and unsecured loans may lead to greater losses. A recent analysis by the New York Fed highlighted that American households owe a total of $17.7 trillion in consumer loans, student loans, and mortgages.
Additionally, credit card issuance and delinquency rates are rising as many 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 that cardholder balances have surpassed the trillion-dollar threshold, according to TransUnion. The commercial real estate sector also remains unstable.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, commented, “We’re still emerging from the COVID era, especially regarding banking and consumer health, largely due to the stimulus that was directed at consumers.”
However, potential challenges for banks are anticipated in the upcoming months. Mark Narron, a senior director at Fitch Ratings, indicated that the provisions seen in any quarter do not always reflect recent credit quality but rather banks’ expectations for future economic conditions.
He noted the shift from a system where rising loan defaults would drive increased provisions to one where macroeconomic forecasts play a significant role in provision levels.
In the short term, banks are expecting slower economic growth, elevated unemployment rates, and possible interest rate cuts later this year. This scenario could lead to heightened delinquencies and defaults as the year ends.
Citi’s CFO Mark Mason pointed out that warning signs are mainly evident among lower-income consumers, who have been depleting their savings since the pandemic. He observed, “While we see an overall resilient U.S. consumer, we also notice significant differences in performance and behavior across income and credit score segments.”
According to Mason, only the highest income quartile has maintained more savings than at the beginning of 2019, with individuals in the over-740 credit score bracket driving spending growth. In contrast, those with lower credit scores are experiencing greater declines in payment rates and are borrowing more due to intensified impacts from high inflation and interest rates.
The Federal Reserve has held interest rates at a 23-year high of 5.25% to 5.5% as it aims for inflation to stabilize at its 2% target before implementing anticipated rate cuts.
Despite banks preparing for possible defaults in the latter part of the year, current default rates do not indicate a looming consumer crisis, according to Mulberry. He highlighted the distinction between homeowners and renters during the pandemic, noting that homeowners benefited from locking in low fixed rates.
While rates have increased significantly since then, homeowners are largely insulated from immediate financial strain, unlike renters, who are facing rising rents and stagnant wage growth. Rents have increased over 30% nationally between 2019 and 2023, while grocery prices have climbed by 25% in that same timeframe.
The recent earnings reports reveal that there were no significant new concerns regarding asset quality. Strong revenues, profits, and resilient net interest income suggest that the banking sector remains in a relatively healthy state.
Mulberry emphasized, “There’s some strength in the banking sector that is reassuring, indicating that the financial system’s structure is still robust at this time.” However, he cautioned that prolonged high interest rates could continue to place stress on the financial landscape.