Banks' easy profits are about to end

America's largest commercial banks reported record headline profits for the fourth quarter, lifted by a big rise in net interest income (NII). JPMorgan Chase, Bank of America and Wells Fargo rode the Federal Reserve's rapid rate rises to historic interest margins, earning billions by lending deposits out at 4.5 per cent while paying depositors next to nothing. JPMorgan's cautious 2023 NII guidance of $73 billion shows that bank bosses know the easy money from cheap deposits has peaked. Zero-cost deposits are gone, and the fight for funding is about to squeeze bank profits.

The 2022 windfall came from what bankers call "deposit beta lag". Early in a tightening cycle, retail and business customers are notoriously slow to move cash out of ordinary current accounts.

How the windfall was built

The deposits themselves arrived in the pandemic. Government relief payments and the Fed's bond buying pushed trillions of dollars into bank accounts in 2020 and 2021, far more than banks could lend. Most of the surplus went into Treasuries and mortgage-backed securities bought at the lowest yields in history, while the deposits cost almost nothing.

When the Fed began raising rates in March 2022, the asset side of that balance sheet started earning more with every increase, especially loans tied to floating benchmarks. The liability side barely moved. The gap between the two is net interest income, and through the second half of 2022 it widened with every meeting of the Fed.

Depositors catch up

Banks quickly repriced floating-rate business loans and credit cards to the new benchmarks while keeping deposit rates near zero, which produced an exceptional windfall on margins.

Once Treasury bills and money market funds pay more than 4.5 per cent, though, depositors stop being lazy. They are pulling hundreds of billions of dollars out of accounts that pay nothing, a few clicks at a time, and moving it into Treasury direct accounts, money market funds and high-yield certificates of deposit.

The evidence is already in the aggregate numbers. Total deposits at American commercial banks have been falling since the spring of 2022, according to the Fed's weekly figures, while assets in money market funds have climbed to a record. Series I savings bonds, which paid 9.62 per cent for part of last year, drew such a rush of savers that the Treasury's website struggled to cope.

Funding gets dearer

To stop deposits walking out of the door, banks will have to raise their deposit betas sharply, paying 3 to 4 per cent just to keep the funding they already have.

Selling assets to meet outflows is an unattractive alternative. The bonds bought in 2020 and 2021 have fallen in value as yields rose, leaving the banking system with hundreds of billions of dollars of unrealised losses on its securities. Selling them would turn paper losses into real ones, so banks will prefer to pay up for deposits or borrow from wholesale markets, both of which cost far more than the funding they are losing.

Loan demand is softening at the same time, as higher borrowing costs cut into mortgage lending and corporate borrowing. Banks also set aside more money for expected loan losses in the fourth quarter, a sign that they expect credit quality to weaken from unusually good levels.

A lesson from the thrifts

The most painful precedent is the savings-and-loan crisis. In the late 1970s and early 1980s, thrifts held long-term mortgages at fixed rates and funded them with deposits whose rates had been capped by regulation. When those caps were phased out and market rates soared, deposit costs rose above the yield on the mortgages, and hundreds of institutions failed over the following decade.

Today's large banks are far better capitalised and hedged, and nothing in their results suggests a repeat. The mechanism is the same in miniature, though: a balance sheet of long, low-yielding assets funded by deposits that can reprice faster than the assets.

Big banks and small

The squeeze will not fall evenly. The largest banks have millions of retail customers who keep money in current accounts for convenience and rarely shop around, so their deposits are stickier. Regional banks that rely more on business deposits and on customers who watch rates closely will have to pay up first and hardest.

Savers are the winners of the shift. For more than a decade households with money in the bank earned close to nothing, and the gains from higher rates went to the banks. Online banks and brokerages offering high-yield savings accounts are now drawing customers away from the big branch networks, and each customer who moves teaches others that it can be done in minutes. The income that flowed to bank shareholders in 2022 will increasingly flow to depositors instead.

The strongest counterargument is that JPMorgan's guidance still implies higher net interest income in 2023 than in 2022, because loans and securities continue to reprice upward while the Fed keeps raising rates. That is correct for the full year. The argument here concerns the direction of margins from their fourth-quarter peak, and on that the banks' own guidance points down.

The signals to watch are the Fed's weekly deposit data, the rates banks advertise on savings accounts and certificates of deposit, and first-quarter results in April, when management teams will update their guidance. The fat margins that flattered bank earnings in 2022 were a one-off, and as funding costs catch up with market rates during 2023, net interest margins will probably shrink and bank shares will lose their main support.