As interest rates reach their highest levels in over two decades and inflation continues to impact consumers, major banks are preparing for increased risks associated with their lending practices.
In the second quarter, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo raised their provisions for credit losses compared to the previous quarter. These provisions are funds that banks set aside to handle potential losses from credit issues, including defaulted loans and troubled commercial real estate (CRE) loans.
JPMorgan allocated $3.05 billion for credit losses in the second quarter; Bank of America contributed $1.5 billion; Citigroup’s allowance reached $21.8 billion, more than tripling its previous quarter’s reserve build; and Wells Fargo set aside $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 greater losses. A recent analysis from the New York Fed revealed that Americans owe a collective $17.7 trillion in consumer loans, student loans, and mortgages.
Credit card issuance and delinquency rates are also rising as consumers deplete their pandemic-era savings and increasingly rely on credit. In the first quarter of this year, credit card balances hit $1.02 trillion, marking the second consecutive quarter with total balances exceeding 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, “We’re still coming out of this COVID era,” emphasizing that the consumer’s financial health has largely depended on governmental stimulus.
However, challenges for banks may materialize in the coming months. Mark Narron, a senior director at Fitch Ratings, explained that the provisions reported by banks do not necessarily reflect recent credit quality but are instead forecasts of future expectations.
“We have shifted from a system where provisions increased as loans began to default to one where macroeconomic forecasts primarily dictate provisioning,” he said.
In the short term, banks anticipate slowing economic growth, rising unemployment, and potential interest rate cuts later this year in September and December. These factors could contribute to an increase in delinquencies and defaults as the year progresses.
Citi’s chief financial officer, Mark Mason, emphasized that emerging red flags seem concentrated among lower-income consumers, who have seen their savings decline since the pandemic.
Although the overall U.S. consumer remains resilient, performance varies significantly across different income levels. Mason noted that only the highest income quartile has increased their savings since early 2019, with those holding credit scores above 740 driving spending growth and exhibiting high payment rates. Meanwhile, lower income consumers are struggling more acutely with high inflation and interest rates.
The Federal Reserve maintains interest rates at a 23-year high of 5.25-5.5%, waiting for inflation to stabilize towards the central bank’s 2% target before considering any rate cuts.
Despite banks gearing up for broader defaults later this year, Mulberry observed that defaults have not yet risen at rates indicative of a consumer crisis. He pointed out the difference between homeowners who locked in low fixed interest rates during the pandemic and renters who did not benefit from those conditions.
While interest rates have significantly increased, many homeowners remain insulated from the pressure, whereas renters face escalating costs. Rents have surged over 30% nationwide from 2019 to 2023, and grocery prices have risen by 25%, leading to significant financial strain for renters whose wages have not kept pace.
Overall, the latest earnings reports show no alarming trends in asset quality. Strong revenues, profits, and healthy net interest income reflect a banking sector that is still in good shape.
“There’s some strength in the banking sector that isn’t entirely unexpected, but it’s reassuring to recognize that the financial system remains solid,” Mulberry concluded. Nonetheless, as high interest rates persist, the potential for increased stress exists.