As interest rates reach levels not seen in over 20 years and inflation continues to pressure consumers, major banks are bracing for heightened risks associated with their lending activities.
In the second quarter, leading financial institutions such as JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo all increased their provisions for credit losses compared to the previous quarter. These provisions represent the funds that banks set aside to mitigate potential losses stemming from credit risk, which includes unpaid debts and loans, particularly in commercial real estate.
JPMorgan allocated $3.05 billion for credit losses during the second quarter, while Bank of America set aside $1.5 billion. Citigroup reported an allowance for credit losses amounting to $21.8 billion as of the quarter’s end, marking more than a threefold increase from the preceding quarter. Wells Fargo’s provisions totaled $1.24 billion.
This build-up in reserves indicates that banks are preparing for a potentially riskier environment where both secured and unsecured loans could result in significant losses. An analysis by the New York Fed highlighted that Americans collectively owe $17.7 trillion in consumer loans, student loans, and mortgages, amplifying the risk landscape for banks.
Credit card issuance and delinquency rates are also rising as individuals deplete their pandemic-era savings and depend increasingly on credit. Credit card balances reached $1.02 trillion in the first quarter of this year, marking the second consecutive quarter where total cardholder balances exceeded a trillion dollars, according to TransUnion. The commercial real estate sector remains particularly vulnerable.
Brian Mulberry, a client portfolio manager at Zacks Investment Management, noted that the banking landscape is still navigating the aftermath of COVID-19, emphasizing that fiscal stimulus played a significant role in consumer health during that period.
Looking ahead, banks face potential challenges in the coming months.
Mark Narron, a senior director in Fitch Ratings’ Financial Institutions Group, explained that quarterly provisions do not necessarily reflect recent credit quality but rather the banks’ future expectations. He observed a shift from a model where rising loan defaults prompted increased provisions to one where macroeconomic predictions dictate provisioning practices.
Currently, banks anticipate slower economic growth, a rise in the unemployment rate, and two interest rate cuts expected later this year in September and December, which may lead to more delinquencies and defaults by year-end.
Citi’s CFO Mark Mason pointed out that red flags appear to be emerging primarily among lower-income consumers, who have experienced a decline in savings since the pandemic began.
“While we continue to see an overall resilient U.S. consumer, there is a noticeable divergence in performance and behavior based on income levels and credit scores,” Mason noted in a recent analyst call.
He highlighted that only the highest income quartile has managed to retain more savings compared to early 2019, with higher FICO score customers pushing spending growth and maintaining strong payment rates. Conversely, those in lower FICO bands are witnessing reduced payment rates and increased borrowing, significantly affected by rising inflation and interest rates.
The Federal Reserve has maintained interest rates at a 23-year high of 5.25-5.5%, waiting for inflation to stabilize towards the target of 2% before implementing anticipated rate cuts.
Despite banks preparing for potential defaults in the latter half of the year, Mulberry observed that current default rates do not indicate an imminent consumer crisis. He is particularly attentive to the differences between homeowners and renters from the pandemic period.
While interest rates have escalated significantly, Mulberry noted that homeowners benefited from locking in low fixed rates and are not feeling financial strain as acutely. In contrast, renters who didn’t secure low rates are facing mounting pressure, with rents climbing over 30% nationwide from 2019 to 2023 and grocery costs rising 25% in the same timeframe.
At present, the key takeaway from the recent earnings reports is that there were no new concerns regarding asset quality. Strong revenues, profits, and resilient net interest income are promising signs for the banking sector.
“There remains strength in the banking sector, which is a positive development, confirming that the financial system’s framework remains robust,” Mulberry stated. “However, we will continue to monitor the situation closely, as prolonged high-interest rates could lead to increased stress.”