Cheap deposits have become a painful pandemic hangover for US banks

The failure of Silicon Valley Bank and the subsequent sell-off of US banks have highlighted the enduring dangers of a strategy many lenders have used to boost profits when interest rates are low.

Banks have become accustomed over the past three years to investing customer deposits in fixed income securities when they have not been able to lend them profitably. The SVB, which was taken over by the US supervisory authorities on Friday, used the strategy particularly intensively: more than half of its assets were invested in securities.

But as interest rates have soared over the past year, the bonds that banks have bought with their abundance of cheap deposits have fallen in value, causing up to $600 billion in paper losses. As a result, investors get a better picture of the risks some banks have taken on their excess deposits.

In extreme cases, as with the SVB, these paper losses can lead to a death spiral in which fearful depositors force banks to liquidate their portfolios, turning these paper losses into real losses that could be too big for some small or even mid-sized banks . This seems to have unsettled investors in bank stocks in recent days.

“I’m going to quote my high school economics teacher who said there was no such thing as a free lunch,” said Greg Hertrich, Nomura’s head of US depositary strategies. “I think there has been more of a tendency to think about the additional income that can be generated from longer duration assets that can be matched with this new pot of excess deposits.”

According to data from the FDIC, as of April 2020 and peaking two years later, nearly $4.2 trillion in deposits flowed into US banks. But only 10 percent of that was ultimately used to fund new loans. Some banks simply held these new deposits in cash. But much of the money, about $2 trillion, has been put into securities, mostly bonds. Before the pandemic, banks had just over $4 trillion in securities investments. Two years later, those portfolios were up 50 percent.

What may have made low-yield borrowing more attractive than new lending, at least low-yielding government bonds or government-guaranteed bonds, was the perception of low credit risk. And for a time, these new bonds ended up eating away at bank profits. But in hindsight, it now looks like the banks bought at the top of the market. And that’s what’s causing the problem now. Last year, lenders’ bond portfolios plummeted in value, causing about $600 billion in losses. However, because banks do not regularly sell their bonds, many of these losses have yet to be realised.

“The banks have fallen asleep. No one expected inflation to continue like this,” said Christopher Whalen, a veteran banking analyst and head of Whalen Global Advisors. “The banks with large treasury books have the most problems.”

Among the big banks, JPMorgan has been more cautious than others. While interest rates were low, Chief Executive Jamie Dimon told investors it was “hard to justify the price of US debt” and that he “wouldn’t touch it.” [Treasuries] with a 10 foot pole”. While JPMorgan raised just over $700 billion in new deposits in the wake of the pandemic, its security holdings increased by just $200 billion over the period.

But when Bank of America’s deposits rose $500 billion after the pandemic began, its bond holdings shot up almost as quickly, rising nearly $480 billion. As a result, BofA’s losses on its securities portfolio have soared to just over $110 billion last year, or more than double the roughly $50 billion in losses recorded at Wells Fargo and JPMorgan.

However, analysts point out that most banks can avoid losses by holding the securities to maturity. This is especially true for the country’s largest banks, which have access to wholesale financing to meet deposit outflows and where losses on securities remain small relative to their overall size. At a time when banks need to offer depositors higher interest rates, the fact that they have to hold on to low-yielding bonds to avoid these losses is likely to eat into profits.

“We think the big banks will do well this year,” said Gerard Cassidy, banking analyst at RBC Securities. “It’s definitely a headwind.”

But what’s just headwind for the country’s biggest banks could be a tornado for some smaller lenders who are heavily betting on their bond portfolios. That happened in large part at Silicon Valley Bank, which racked up $15 billion in losses on its bond portfolio, only slightly less than the bank’s total worth.

Beverly Hills, California-based PacWest, for example, has amassed $1 billion in losses on its bond portfolio, enough to wipe out more than a quarter of its $4 billion in equity. PacWest shares have plummeted 50 percent over the past week.

“Most banks are not insolvent,” Whalen said. “But every bank is sitting on losses.”