The real cost of the banking crisis: customers want interest

JPMorgan Chase opened the first-quarter bank earnings season with record net revenue of $38.3 billion and a 52 per cent jump in net income. As the obvious safe haven during the March panic over regional banks, it took in $50 billion of deposits. Jamie Dimon's results carried a warning for the rest of the industry, though. The lasting cost of the regional banking crisis is that depositors have finally noticed interest rates, and they want to be paid.

For a decade banks sat on a vast pool of deposits that paid no interest, current accounts and operating cash that earned nothing while the banks earned market rates on their assets. That free funding was the foundation of bank profits.

Why the record came so easily

The record was built on the Federal Reserve. Since March last year the Fed has raised its policy rate from near zero to a range of 4.75 to 5.00 per cent, and JPMorgan's floating-rate loans, cash balances at the central bank and short-dated securities all reset upward. Its deposit costs rose far more slowly. The gap between the two, net interest income, drove the quarter, and the bank raised its forecast for net interest income over the rest of the year.

That forecast assumes the bank keeps paying depositors much less than the market. Management conceded that deposit rates would have to rise and that the recent pace of income growth would not last. The same results that showed JPMorgan winning the crisis also showed the mechanism that will squeeze everyone else.

Free funding runs out

March woke up millions of corporate treasurers and wealthy savers. Even at JPMorgan, non-interest-bearing deposits fell 8 per cent in the quarter as customers moved money into interest-bearing certificates, Treasury bills or money market funds.

For regional banks the shift is a threat to survival. To hold on to deposits, small and mid-sized lenders are having to raise deposit rates sharply, offering certificates of deposit at 4 to 5 per cent to stop customers decamping to the Wall Street giants or to money funds.

The mechanics favour the giants. A large bank earns fees from payments, cards, trading and asset management, and its size lets it spread the cost of branches and technology over a huge customer base. It can afford to pay a little more on deposits without losing money. A regional lender that earns most of its revenue from the spread between loans and deposits has no such cushion, and each point it adds to deposit rates comes straight off its margin.

How margins get squeezed

The squeeze works through the mix of deposits as much as their price. When a customer moves money from a current account paying nothing into a certificate of deposit paying 4 per cent, the bank's funding cost on that money jumps overnight, even if it has not changed a single posted rate. Economists call the share of a rate rise passed on to depositors the deposit beta, and it tends to start low and then climb as customers wake up. March brought that awakening forward by several months.

The asset side cannot keep up. Much of what banks bought in 2020 and 2021 was fixed-rate mortgages and Treasuries yielding 2 per cent or less, which will not reprice until they mature or are sold. New loans can be written at higher rates, but banks are cutting new lending to conserve capital and liquidity. The result is a period in which funding costs rise faster than asset yields, and it can last for several quarters.

Margins will shrink

The days of funding 4 per cent loans with 0.1 per cent deposits are over. As banks reprice their deposits toward 4.5 per cent, net interest margins will probably shrink hard through the second half of 2023.

JPMorgan and the other giants may have won the scramble for frightened deposits, but they have lost the fight for cheap funding. Wealthy clients who moved money there for safety will soon ask why it earns less than a Treasury bill, and the bank will have to answer with a higher rate.

The last full tightening cycle offers a guide. When the Fed raised rates steadily between 2004 and 2006, bank deposit costs lagged at first and then caught up, and margins narrowed as the cycle went on even though the policy rate stayed high. The difference now is speed. Digital banking and money funds have made it easier than ever to move cash, so the catching-up phase is likely to be faster and sharper than it was then.

Winners and the counter-case

The winners are savers, who at last earn a return on idle cash, and the largest banks, whose share of the deposit market is rising. The losers are regional lenders and their shareholders, and eventually borrowers, since banks with dearer funding will charge more for loans or make fewer of them. Small businesses and commercial property owners, who depend on regional banks, are the most exposed.

The strongest case against a severe squeeze is that banks start from very high margins. The rise in rates over the past year lifted income far faster than costs, and some compression would merely return margins to normal levels. Banks with plenty of floating-rate loans can also offset part of the rise in deposit costs, and if the Fed stops raising rates soon, the pressure on deposit pricing may ease. That argument holds for the strongest lenders. It does little for banks whose assets are locked into low fixed rates and whose depositors have already shown they will leave.

The rest of the earnings season will show how widespread the pressure is. Regional banks report over the next two weeks, and their deposit costs, the share of deposits paying no interest and their guidance for net interest income are the numbers to watch. The FDIC's quarterly profile of the whole industry, due in late May, will give the fuller picture. The banking system survived March. What it lost was free customer cash in a five per cent world, and bank earnings are likely to show the damage from the second half of 2023.