Banks' profit peak is here

JPMorgan Chase reported net interest income of nearly $23 billion for the third quarter, helped by high policy rates and its ability to pay depositors little. Results from America's biggest banks looked splendid at first glance. Executives on the calls sounded far more cautious than the headlines. Bank profits are probably at their cyclical peak.

How the windfall was built

The Federal Reserve raised its policy rate from near zero in March 2022 to a range of 5.25 to 5.50 per cent by July this year. Loans priced off short-term rates, such as corporate credit lines and credit cards, repriced almost at once. Deposits did not. Households and companies had piled up cash during the pandemic, and for months most left it in current and savings accounts paying next to nothing, so the gap between what banks earned and what they paid widened to levels not seen in years.

JPMorgan had an extra boost. In May it bought First Republic, the failed Californian lender, in a deal arranged by the Federal Deposit Insurance Corporation, adding a large book of loans and deposits on favourable terms. The biggest banks also gained deposits from nervous customers of regional lenders after Silicon Valley Bank collapsed in March. Size became a selling point in a year when depositors worried about which banks might fail.

Depositors want their share

For eighteen months banks earned an unusually fat margin by raising deposit rates slowly while the yields on their assets reset higher. That easy money is running out. Companies and households are moving cash into higher-yielding Treasury bills and money market funds, and banks have to pay depositors more to keep them. Unrealised losses on securities portfolios still limit what banks can do with their balance sheets.

The mechanism is what bankers call the deposit beta, the share of a rise in policy rates that is passed on to savers. Early in a tightening cycle it is low, because customers are slow to move. Later it rises, as corporate treasurers and wealthier savers shift into instruments that pay close to the policy rate. Treasury bills now yield more than 5 per cent, and money-market fund assets have reached a record, so each month more cash leaves low-cost accounts or has to be retained with higher rates.

The bond book's shadow

Those securities losses explain why banks cannot easily grow their way out of the squeeze. Much of the money that flooded in during 2020 and 2021 was invested in Treasuries and mortgage-backed securities at yields of 1 to 2 per cent. With ten-year yields now near their highest since 2007, those bonds are worth far less than banks paid for them. Selling them would crystallise the loss and hit capital, so banks are stuck earning low yields on a large slice of their assets until the bonds mature.

Regulation adds to the pressure. In July the Fed and other regulators proposed the final pieces of the Basel III capital rules, which would require large banks to hold more capital against trading and lending. Banks have responded by building capital, slowing buybacks and becoming choosier about new loans. Holding more capital lowers returns on equity even when revenue is strong.

Winners and losers among lenders

The squeeze will not fall evenly. The largest banks have diversified income from trading, investment banking and payments, and their deposit franchises remain the cheapest in the system. Regional banks, which rely more on interest income and have lost more deposits since March, face a harsher adjustment. Many have been borrowing from the Federal Home Loan Banks or the Fed's emergency Bank Term Funding Programme, which costs far more than retail deposits. Lenders heavy in commercial property loans, especially on offices, face credit losses on top of the margin squeeze.

Savers are the obvious winners. For the first time in more than a decade they are being paid a real return on cash, and competition among banks for deposits is pushing that return higher. Borrowers are the losers, since banks trying to protect margins will tighten lending standards and keep loan rates high even if the Fed stops raising them.

The case for a longer run

The counterargument is that margins may hold up for longer than feared. If the Fed keeps rates high well into next year, as its September projections suggest, banks' floating-rate assets will keep earning more, and older low-yielding bonds will gradually mature and be reinvested at today's yields. A strong economy with low unemployment also means that credit losses remain modest. On that view, net interest income plateaus rather than falls.

That argument has merit, but it describes a plateau, and share prices are set on changes at the margin. The precedent of 2006 and 2007 is unhelpful for optimists: once the Fed stopped raising rates, deposit costs kept catching up while asset yields stalled, and margins narrowed before the credit cycle turned. JPMorgan's own management spent much of its call warning about risks, from geopolitics to the possibility that rates stay higher for longer than markets expect. The indicators to watch are weekly deposit data from the Fed, the pace at which banks raise savings rates, and net interest income guidance for next year when fourth-quarter results arrive in January.

This quarter's record earnings are probably as good as it gets for the big banks in this cycle. Funding costs will keep rising, and competition for deposits will squeeze margins through next year, with regional lenders feeling it first and hardest.