Matt Levine / Money Stuff: The deposit franchise

Old_Joe

The basic question about this year’s US regional banking crisis is “why weren’t the banks prepared for the very predictable problems that they faced when interest rates went up,” and the basic answer is “because they thought rates going up would be good for them.”

We have talked about this a few times around here, and I have described two theories of banking. In Theory 1, banks have short-term deposits and invest them in long-term assets, so when interest rates go up, their costs go up (they have to pay more on their deposits) while the value of their assets goes down (those assets continue to pay fixed rates, and now are worth less). Rising rates are bad. In Theory 2, bank deposits are actually long-term, because the banks have enduring relationships with their customers and their customers are unlikely to leave, or demand higher rates, as interest rates go up. And so banks can use those long-term-ish deposits to fund long-term assets, and as interest rates go up, the banks can earn higher rates, don’t have to pay higher rates, and so make more money. Rising rates are good. Theory 2 is the traditional theory of banking, and it is why many banks were not adequately prepared for rising rates.

At the Wall Street Journal today, Jonathan Weil and Peter Rudegeair report on Theory 2:

The recent spate of bank failures is upending a long-held theory among banking executives and regulators—that the value of a lender’s deposit business goes up when interest rates move higher.

The theory rests on an assumption: That banks don’t have to pay depositors much to keep their money around, even as rates rise. The deposits would be a stable source of low-cost funding while the bank earned more money lending at higher rates.

The more rates rose, the bigger the franchise value of those deposits would become—a natural hedge against the declining market values of a portfolio of fixed-rate loans and bonds.

But if rising rates or plunging asset values cause a bank’s depositors to flee en masse, the franchise value is zero—and, worse, it could beget other bank runs. That is what happened with Silicon Valley Bank. …

The Federal Reserve, which both regulates banks and sets interest-rate policy, in a November report pointed to large unrealized losses on banks’ bondholdings due to rising rates. Things weren’t so bad, the Fed said, because “the value of banks’ deposit franchise increases and provides a buffer against these unrealized losses.”

Not really! And yet Theory 2 has some truth to it, just not so much for regional banks:

JPMorgan Chase lifted its outlook for how much it expects to earn this year from its lending business following the recent purchase of First Republic, bucking a broader trend among US banks of shrinking profits owing to deposit withdrawals.

In a presentation for its investor day on Monday, JPMorgan lifted its 2023 target for net interest income (NII), excluding its trading division, to about $84bn from $81bn previously, because of its deal for First Republic. NII is the difference between what banks pay on deposits and what they earn from loans and other assets. …

Large lenders such as JPMorgan have benefited from the US Federal Reserve lifting interest rates last year, which enabled them to charge borrowers more for loans without passing on significantly higher rates to savers.

The bank said its deposits, which totalled $2.3tn at the end of March, were “down slightly” year on year. Chief financial officer Jeremy Barnum said the expectation was that system-wide deposits at US banks would continue to decline as the Fed tightened monetary policy and customers chased better yields on their cash.

“We will fight to keep primary banking relationships but we are not going to chase every dollar of deposit balances,” Barnum added.

JPMorgan is paying 1.21 per cent on average to depositors, lower than the 1.75 per cent average of its peers, according to data from industry tracker BankReg.

See, that’s a deposit franchise. Having a valuable deposit franchise means that you don’t have to chase every dollar of deposits, because they don’t go anywhere.

Derf

@Old_Joe : Good post. Why do you think more people don't move their money ? When rates were .5% to 1% I can understand not moving your money, but at rates around 5% why not make the move ?

For the first time ever I received a personal note from bank thanking me for being a customer. It was kind of hard to believe as I had moved half of my cash out & only kept a higher amount to cover a new vehicle purchase.