Big banks are bracing for losses as Americans struggle to pay off debt

• American consumers and businesses are having a hard time paying off credit card, auto, and commercial real estate debt.
• US banks have increased their reserves in part to prepare for potential loan losses.
• Bank CEOs said on recent earnings calls that elevated prices and interest rates continue to weigh on Americans.

US banks are having a harder time collecting debts, so they're taking precautions.

According to Federal Reserve data, the past-due debt share for credit card, auto, and commercial real estate has recently risen to above pre-pandemic levels. The share of debt banks have written off as a loss because they couldn't collect it has also ticked up, with the charge-off rate for two of these three loan types the highest they've been in more than a decade.

Business Insider spoke to industry insiders who said this has prompted a response from big banks anticipating a continued increase in bad loans. US banks have increased their reserves in recent years, effectively setting aside cash to cover potential loan losses.

While it's commonplace for banks to increase their reserves as loan levels rise over time, reserves have started gradually making up a bigger share of total loans at firms like Wells Fargo, Bank of America, JPMorgan, and Citigroup. Since June 2022, Wells Fargo's and Bank of America's reserves have risen by about $1.8 billion and $2.4 billion respectively. Still, for context, these firms' cash coffers are still considerably lighter than they were during the Great Recession.

America's 3 debt pain points

Each month, the New York Fed asks roughly 1,300 Americans to estimate the chance they'll be unable to make a minimum debt payment over the next three months. Aside from the pandemic, Americans haven't been this pessimistic since 2017.

Consumers' struggles to repay credit card and auto debt suggest that inflation and interest rates, while moderating in recent months, are still taking a toll on their finances. Additionally, businesses' struggles to pack back commercial real estate debt show that factors like elevated interest rates and the remote work revolution are still having lingering effects.

Here's a closer look at each of the three debt categories:

Credit card debt

As of the second quarter of this year, more than 3% of all credit card accounts in the US had past-due balances — up from less than 2% in 2021.

The steady uptick in past-due credit card debt over such a short period of time provides some cause for concern, Bruce McClary, a nonprofit credit counselor and senior vice president at the National Foundation for Credit Counseling, told BI.

"What we are seeing is that people are struggling to repay debt while continuing to use up what is left of their available credit — forcing more people to start falling behind on their payments and into the hands of debt collectors," he said.

David Schiff, senior managing director at FTI, told BI that prolonged debt-repayment problems will eventually present a bigger risk to the economy.

The increase in reserves raises "real concerns about the softness of certain assets classes — specifically ongoing uncertainty around the commercial real estate market, and increasing worry about the number of revolving credit card customers and their rapidly growing balances," Schiff told BI.

Auto debt

A Federal Reserve report published on September 26 found that auto loan delinquency rates rose "substantially" above pre-pandemic levels by the end of 2023, driven in large part by growth in monthly debt payments.

In fact, a growing number of Americans owe more than their cars are worth, according to a report published on October 15 by the automotive website Edmunds. Stephen Biggar, director of financial services research at Argus Research, told Business Insider that if a bank is forced to repossess such a vehicle, the car's value wouldn't even cover the loan, resulting in losses to the bank. He said that the uptick in auto delinquencies is "not a spike, but is kind of a concern about what goes on from here."

Commercial real estate

Another problem for banks is that some businesses with commercial real estate loans are struggling to repay them. Biggar said some of this is tied to high vacancy rates among offices. While many companies have called employees back to the office since the height of the pandemic, office vacancy rates still rose to record highs over the past year.

Elevated interest rates have also made it difficult for businesses to pay back debt on commercial real estate loans related to offices, retail, hotel, and apartment building properties, among others. That's because some loans are coming due — forcing businesses to refinance at much higher interest rates.

To be sure, we're still far from a debt crisis: The share of past-due and charged-off debt generally remains in line with historical levels after rising from pandemic-era lows. Additionally, some banks are simply restoring reserves that were depleted during the pandemic. However, if the economy slows and the unemployment rate rises further, the uptick in delinquencies could become a larger concern, Biggar said.

Wall Street acknowledgement

While banking executives this earnings season generally spoke highly of the economy, they did acknowledge that elevated prices and interest rates continue to weigh on American consumers.

"Our customers are healthy, but more discerning in their spend with signs of stress isolated," said Jane Fraser, Citi's CEO, referring to consumers with lower credit scores.

Brian Moynihan, Bank of America's CEO, said that overall consumer spending remains strong but that "consumers are worried of the cost of living, worried about higher rates, and other matters."

Charles Scharf, Wells Fargo's CEO, said the bank hasn't seen "meaningful changes" in delinquency rates across its credit portfolio, but that there is evidence of financial strain among some Americans.

"We continue to see more pronounced stress in certain customer segments with lower deposit and asset levels where inflation has partially offset strong employment and wage growth," he said.

Jeremy Barnum, JPMorgan's CFO, said that consumers' discretionary spending has "normalized" following particularly strong levels in recent years.

The financial roller coaster of pandemic payments, whipsawing inflation, and high interest rates are especially affecting lower-income Americans.

"We know consumers at a certain income level and below are strapped," Biggar said, adding, "There's been a lot of concern, particularly at the lower income category, that people are unable to make ends meet."

Going forward, Biggar said that many banks could continue adding to their reserves, particularly if the unemployment rate rises further. That might not ultimately be necessary, since the jobless rate has stabilized over the past two months after a surprise increase.

"I'm not expecting any big spike from here unless the unemployment rate moves materially higher," Biggar said of further reserve reinforcements.