As interest rates remain at their highest levels in over two decades and inflation continues to challenge consumers, major banks are bracing for greater risks associated with their lending activities.
In the second quarter, prominent banks such as JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo increased their provisions for credit losses compared to the previous quarter. These provisions are funds set aside by financial institutions to cover potential losses stemming from credit risks, including delinquent loans and commercial real estate (CRE) lending.
JPMorgan set aside $3.05 billion for credit losses in the second quarter, while Bank of America reserved $1.5 billion. Citi’s total allowance for credit losses reached $21.8 billion at the end of the quarter, more than tripling its previous quarter’s reserve, and Wells Fargo reported provisions of $1.24 billion.
These reserves indicate that banks are preparing for a riskier financial landscape, where both secured and unsecured loans could result in significant losses for some of the largest U.S. financial institutions. A recent analysis by the New York Federal Reserve revealed that American households collectively owe approximately $17.7 trillion across consumer loans, student loans, and mortgages.
Issuance and delinquency rates for credit cards are also climbing as individuals exhaust their pandemic-era savings and increasingly rely on credit. According to TransUnion, credit card balances reached $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where combined balances exceeded the trillion-dollar threshold. CRE continues to be in a fragile position as well.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, noted that the financial sector is still navigating the aftermath of COVID-19, highlighting the role of stimulus measures that were provided during the pandemic.
Challenges for banks are anticipated in the coming months. “The provisions you see each quarter do not solely reflect past credit quality; they also represent banks’ expectations for the future,” said Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group.
He explained that there has been a shift from a system where provisions increased after loans began to deteriorate to one driven by macroeconomic forecasts.
In the near future, banks are forecasting slowing economic growth, a rising unemployment rate, and anticipate two interest rate cuts later this year in September and December, which could lead to increased delinquencies and defaults as the year ends.
Citi’s Chief Financial Officer Mark Mason highlighted that these warning signs seem most pronounced among lower-income consumers, who have seen their savings decline since the pandemic began.
“While we still observe a resilient U.S. consumer overall, performance and behavior significantly differ across income levels and credit scores,” Mason remarked during a recent analyst call.
He pointed out that only the highest income quartile has managed to accumulate more savings compared to early 2019, with higher credit score customers driving spending growth and maintaining timely payment rates. In contrast, those with lower credit scores are experiencing notable declines in payment rates and increasing reliance on borrowing, feeling the acute impacts of high inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5% as it awaits stability in inflation metrics toward its 2% target before considering the expected rate cuts.
However, despite the banks’ preparations for potential defaults, current default rates do not indicate an impending consumer crisis, according to Mulberry. He is monitoring the divide between homeowners and renters, noting that while interest rates have increased significantly, homeowners have largely benefitted from locking in low fixed rates during the pandemic, allowing them to avoid financial strain.
In contrast, renters, who did not have the same opportunities, are facing significant challenges as rents have surged over 30% from 2019 to 2023, accompanied by a 25% rise in grocery costs, leading to heightened financial pressure as these increases outpace wage growth.
Nonetheless, the latest earnings reports reveal “nothing new this quarter in terms of asset quality,” as noted by Narron. Strong revenues, profits, and resilient net interest income are encouraging signs that the banking sector remains robust.
“There are still strong indications within the banking sector, which may not have been entirely unexpected, but it is reassuring to confirm the solid structures of the financial system are currently stable,” Mulberry concluded. “However, we need to remain vigilant, as prolonged high-interest rates will inevitably create more stress.”