The Lex Newsletter: US banks brace for more paper bond losses

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Dear reader,

The postcard flyers and emails from local banks exhorting me to open an account are coming in thick and fast these days. “$300 bonus!” exclaims one from Citizens Bank. Another, from Chase Bank, tells me I can “earn $600!” by signing up for a checking and a savings account. Even credit card companies are jumping in, with American Express offering $250 to new current account customers.

US banks are competing with each other to lure or retain customer cash this year after the collapse of Silicon Valley Bank and two other lenders triggered an exodus of deposits across the banking system.

Competitive pressure has intensified in recent weeks amid a sharp run-up in US bond yields. The yield on the 10-year US Treasury note has jumped from about 3.7 per cent in mid-July to hit a 16-year high of 4.8 per cent this month. The 30-year government bond yield, which ended the third quarter with the biggest quarterly jump in more than a decade, also hit a 16-year high of almost 5 per cent this month.

For US banks, higher interest rates are a double-edged sword. That is something to think about as the third-quarter earnings season for the banking sector kicks off this week. 

On the one hand, banks can make a lot more money on lending. The 30-year fixed mortgage rate average is now 7.5 per cent, compared with 3.1 per cent at the start of 2022. In the second quarter, net interest margins rose at most big US banks, as shown in the chart below from the Federal Deposit Insurance Corporation.

The flip side is that a rising rate environment tends to stymie demand for loans. And there are signs that loan growth is faltering. At the same time, customers are demanding better returns on their savings. Many have already moved their cash into higher-yielding time deposits or money market funds. 

Assets invested in US money market funds hit a record $5.7tn this month. Deposits across US banks have fallen more than $229bn since March to $17.4tn, according to Federal Reserve data. 

To compete, banks have to stump up. They are raising their rates on everything from savings accounts to certificates of deposit. The average share of interest-bearing deposits in the US banking industry increased to 72 per cent in the first quarter, up from 69 per cent a year ago, according to Deloitte.

One metric to keep an eye on is “deposit beta”. This is the share of Fed rate rises that banks passed along to depositors. Analysts at Morgan Stanley reckon cumulative deposit beta across large US banks will hit 47 per cent this year, up from 30 per cent at the end of last year.

Faltering loan demand and higher funding costs will squeeze banks’ net interest margins. Banks also tend to hold large exposure to commercial property loans that could be difficult to refinance if rates stay higher for longer. 

In addition, higher rates can hurt banks by eroding the value of bonds and loans that banks acquired or issued when rates were lower. US banks were sitting on $558bn of unrealised losses in their securities portfolio at the end of June, as this second chart from the FDIC shows.  

After Silicon Valley Bank collapsed in March, investors have focused on the risks posed by paper losses on bond holdings across the industry. This means any sign of a resurgence of unrealised losses in the third quarter could put fresh strain on banks’ balance sheets. 

Many financial groups are already borrowing heavily under the Fed’s Bank Term Funding Program. The scheme reported $121bn in outstanding loans at the end of August. Such loans, which must be repaid within a year, are considered a relatively expensive source of liquidity. This explains why banks are all dangling promotions to attract depositors’ cash. It is seen as a cheaper and more stable source of funding.

Mid-sized and smaller institutions could struggle to retain low-cost deposits. These days big lenders such as JPMorgan Chase, with multiple revenue streams, are seen as safer.

Yet that does not mean big banks will coast through this earnings season either. Rising deposit costs will leave US banks less room to navigate other headwinds. These include continued weakness in investment banking and new capital requirements under Basel III. 

Of the Big Six banks, Citigroup, Goldman Sachs, Wells Fargo and Morgan Stanley are all expected to report a drop in their earnings per share this quarter. JPMorgan will be the exception. It is predicted to post a roughly 25 per cent jump in its EPS. Earnings at Bank of America are forecast to be flat.

Both the KBW Regional Banking index and the broader KBW Bank index remain down more than 22 per cent for the year to date. That compares with the S&P 500’s 14 per cent gain. The wild swings in bank stocks seen in March are over. But the sector’s challenges remain.

Enjoy the rest of your week.

Pan Kwan Yuk
Lex writer