Bank profits hold up in a higher-for-longer world

First-quarter results from Wall Street's biggest banks showed how well they have adapted to high interest rates. JPMorgan Chase reported solid profits and guided for full-year net interest income of roughly $90 billion. Diversified lenders, it seems, can do well when rates stay 'higher for longer'.

Two years of tightening

The setting is the sharpest tightening cycle in four decades. The Federal Reserve began raising rates in March 2022 and has held its target range at 5.25 to 5.5 per cent since last July. For most of that period banks enjoyed the easy half of the adjustment: loan yields rose with the policy rate while deposit rates lagged far behind. The hard half began last year, as savers noticed what money-market funds were paying and started to move.

That shift exposed the weakest balance sheets. Silicon Valley Bank and Signature Bank failed in March 2023, and First Republic followed in May, when JPMorgan bought most of its business from the government. The Fed opened an emergency lending facility for banks in March 2023, and it stopped making new loans under that programme only in March of this year. The episode left a clear split between lenders whose depositors stay put and those whose depositors do not.

Older loans reprice upwards

Deposits cost more than they did, but the banks are making up for it as term assets reprice. Corporate revolving credit lines, commercial loans and newly bought securities are rolling over at yields of five and six per cent, which lifts interest income. For the strongest balance sheets the result is a steady stream of cash that shields shareholders from the pressure hurting regional rivals.

The arithmetic works in stages. Floating-rate corporate loans reset within weeks of each Fed move, so they captured the higher rates early. Fixed-rate assets take longer: bonds bought in 2020 and 2021 at low yields are maturing over several years, and each one that rolls off is replaced by paper paying several times as much. Because the policy rate has stopped rising, the pace at which banks must raise deposit rates is slowing, while that slow rollover of old assets keeps adding income quarter after quarter.

Why size matters for funding

The biggest banks hold an advantage that is hard to copy. Millions of customers keep their salaries and household bills in current accounts at the largest institutions, and those balances pay little or nothing because customers value convenience, branch networks and the assumption that a bank of that size will not be allowed to fail. A lender with that base can let its rate-sensitive corporate deposits drift away and still fund its loan book cheaply.

A mid-sized regional bank has a different mix. More of its funding comes from businesses and wealthier savers who compare rates, and more of its lending sits in commercial property, where office values have fallen sharply since the pandemic changed working habits. New York Community Bancorp showed the danger this year: after large provisions against property loans and a dividend cut, it needed a capital injection of more than $1 billion from a group of investors led by the firm of Steven Mnuchin, a former Treasury secretary.

Who gains and who pays

The winners are shareholders of the largest diversified banks, whose investment banking and trading arms are also recovering as companies return to bond and share markets. Savers gain too, at least those willing to move cash into money-market funds or higher-paying accounts, which now offer real returns for the first time in over a decade. Borrowers on floating rates pay the bill, from private-equity-backed companies to property owners who must refinance loans taken out when money was cheap.

Regional banks are squeezed from both sides. Their deposit costs rise as customers demand more, and their ability to raise asset yields is constrained by the losses already sitting on older bonds and property loans. Selling those bonds to reinvest at higher rates would crystallise losses and eat into capital, so many prefer to wait for them to mature, which takes years.

The case against the big banks

The strongest objection is that higher rates eventually hurt credit quality. Card delinquencies have been rising back towards pre-pandemic levels, and borrowers who refinance commercial property at today's rates will default more often than they did. If losses mount, provisions will absorb much of the extra interest income, even at the largest lenders.

A second risk comes from regulators. The Fed and other agencies proposed last July a revision of capital rules, known as the Basel III endgame, which would require the biggest banks to hold more capital, and the industry is lobbying hard for it to be diluted. Tougher final rules would limit buybacks and dividends. Neither risk undoes the argument, because the largest banks enter this period with thick capital cushions and diversified earnings, but both could trim the returns shareholders now expect.

What would change the picture

The most important variable is the path of the policy rate. A run of hot inflation figures would push rate cuts further out and extend the good times for asset-sensitive lenders, while a sudden weakening of the economy would bring cuts sooner and lower the yields on floating-rate loans. Weekly Fed data on bank deposits will show whether funding outflows at smaller lenders are easing or resuming. Charge-off rates in the second-quarter results, and the shape of the final capital rule, will show how much of the extra income banks can keep.

High base rates are good business for big banks with cheap, loyal deposits. Regional lenders without that funding base will keep feeling the squeeze for as long as rates stay where they are. If the Fed holds through the summer, expect the biggest banks to meet their income guidance while more regional lenders cut dividends, sell loan books or look for merger partners before the year is out.