With interest rates at their highest levels in over two decades and persistent inflation affecting consumers, major banks are preparing for increased risks associated with their lending operations.
Jerome Powell’s keynote address at Jackson Hole this Friday has the potential to influence market dynamics significantly.
In the second quarter of the year, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all increased their provisions for credit losses compared to the previous quarter. These provisions serve as reserves that banks allocate to safeguard against potential losses stemming from credit risk, such as overdue payments and bad debts, particularly concerning commercial real estate loans.
JPMorgan allocated $3.05 billion in provisions; Bank of America set aside $1.5 billion; Citi’s credit loss allowance rose to $21.8 billion at the end of the quarter, more than tripling its reserves from the previous period; and Wells Fargo’s provisions amounted to $1.24 billion.
This increase in reserves indicates that banks are bracing for a more volatile lending environment, where both secured and unsecured loans could lead to higher losses. According to a recent analysis by the New York Fed, total household debt in the U.S. has reached $17.7 trillion, encompassing consumer loans, student loans, and mortgages.
Furthermore, the issuance of credit cards and the associated delinquency rates have been rising, as many individuals exhaust 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 total balances surpassed the trillion-dollar threshold, according to TransUnion. The commercial real estate sector remains precarious as well.
“We are still recovering from the impacts of COVID, and the health of consumers has largely depended on the stimulus that was provided to them,” remarked Brian Mulberry, a client portfolio manager at Zacks Investment Management.
However, any challenges facing banks are expected to materialize in the upcoming months.
“The provisions reported in any given quarter do not solely reflect credit quality from the prior three months; rather, they anticipate future trends,” explained Mark Narron, a senior director at Fitch Ratings’ Financial Institutions Group.
He noted, “It is intriguing, as we have shifted from a traditional approach where increasing defaults would lead to raised provisions, to a system ultimately influenced by macroeconomic forecasts.”
In the short term, banks are forecasting a deceleration in economic growth, alongside a rise in unemployment rates, with anticipated interest rate cuts later this year in both September and December. This scenario may result in increased delinquencies and defaults as the year concludes.
Citi’s chief financial officer, Mark Mason, highlighted that concerns seem to be more prevalent among lower-income consumers, who have seen their savings diminish since the pandemic began.
“While the U.S. consumer remains largely resilient, there exists a noticeable divergence in financial performance and repayment behavior across different income levels and credit scores,” Mason stated during a recent analyst call.
“Among our consumer clients, only those in the highest income quartile have accumulated more savings since 2019, and it is primarily the higher-scoring FICO customers who are driving spending growth with strong payment rates,” he added. “In contrast, lower FICO score customers are experiencing notable declines in payment rates as they increasingly borrow to manage the burdens of rising inflation and interest rates.”
The Federal Reserve has maintained interest rates at a 23-year high of between 5.25% and 5.5%, as it waits for inflation metrics to stabilize closer to its target of 2% before considering any anticipated rate reductions.
While banks are currently preparing for a potential rise in defaults later this year, Mulberry notes that defaults have not yet escalated to a level indicative of a consumer crisis. He is particularly observing the differences between homeowners and renters during the pandemic.
“Although interest rates have increased significantly, homeowners benefited from locking in low fixed rates on their debts, which shields them somewhat from the financial strain,” Mulberry explained. “Conversely, renters did not have this advantage.”
With rents soaring over 30% nationally from 2019 to 2023 and grocery prices climbing 25% in that same timeframe, renters who missed the opportunity to secure low rates are facing the most significant stress on their budgets.
For now, the key takeaway from the latest earnings reports is that “there was nothing notably alarming this quarter regarding asset quality,” according to Narron. In fact, robust revenues, profits, and strong net interest income suggest that the banking sector remains healthy.
“There is a degree of strength in the banking sector that might not have been entirely anticipated, but it is indeed reassuring to see that the financial system’s structure remains robust and sound at this time,” Mulberry remarked. “However, we are monitoring the situation closely; prolonged high interest rates will inevitably cause more stress.”