Cheap deposits have become a painful pandemic hangover for US banks

The failure of Silicon Valley Bank and the sell-off in US banks that followed have highlighted the lasting dangers of a strategy many lenders used to boost profits when interest rates were low.

Over the past three years, banks became accustomed to investing customer deposits in fixed-income securities when they could not profitably lend them out. SVB, which was taken over by US regulators on Friday, was a particularly heavy user of the strategy: more than half of its assets were invested in securities.

But as rates have jumped in the past year, the bonds that banks bought with their bounty of cheap deposits have sunk in value, creating as much as $600bn in paper losses. As a result, investors are getting a better picture of the risks some banks have been taking with their excess deposits.

In extreme cases, such as with SVB, those paper losses can lead to a death spiral in which anxious depositors force banks to liquidate their portfolios, turning those paper losses into real ones that might be too big for some small or even midsized banks to handle. That appears to be what spooked investors in bank stocks in recent days.

“I’m gonna quote my high school economics teacher who said there is no such thing as a free lunch,” said Greg Hertrich, Head of US Depositary Strategies at Nomura. “I think that there was more of a bias towards thinking about the additional income that can be gained by having longer duration assets, matching off against this new pot of surge deposits.”

Starting in April 2020 and peaking two years later, nearly $4.2tn in deposits poured into US banks, according to data from the FDIC. But just 10 per cent of that ended up funding new lending. Some banks just held those new deposits in cash. But much of the money, some $2tn, was funnelled into securities, mostly bonds. Prior to the pandemic, banks had just over $4tn in securities investments. Two years later those portfolios had risen by 50 per cent.

What may have made low-yielding bonds more attractive than new lending, at least low-yielding government, or government-guaranteed bonds, was a perception of low credit risk. And for a time those new bonds did end up juicing bank profits. But in retrospect it now appears that banks may have been buying at the top of the market. And that is what is now causing the problem. Last year, the lenders’ bond portfolios plunged in value, creating some $600bn in losses, though since banks do not regularly sell their bonds, much of those losses have yet to be realised.

“The banks fell asleep. No one expected this continued inflation,” said Christopher Whalen, a longtime bank analyst who is the head of Whalen Global Advisors. “The banks with big Treasury books have the most problems.”

Among big banks, JPMorgan was 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 [Treasuries] with a 10-foot pole”. While JPMorgan took in just over $700bn in new deposits after the pandemic, its securities holdings during that period only rose by $200bn.

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

Analysts, however, point out that most banks can avoid taking losses by holding the securities to maturity. That is particularly true for the nation’s largest banks, which can draw on wholesale funding to cover outflows in deposits, and where losses on securities remain small compared to their overall size. Still, at a time when banks are having to offer higher interest rates to depositors, the fact that they have to hold on to low-yielding bonds in order to avoid those losses is likely to pinch profits.

“We think the big banks will be just fine this year,” said Gerard Cassidy, a bank analyst at RBC Securities. “It’s a headwind for sure.”

But what is just a headwind for the nation’s largest banks could be a tornado for some smaller lenders that bet heavily on their bond portfolios. That is in large part what happened at Silicon Valley Bank, which accumulated $15bn in losses in its bond portfolio, only slightly less than the overall worth of the bank.

PacWest, which is based in Beverly Hills, California, for example, has accumulated $1bn in losses in its bond portfolio, enough to wipe out more than a quarter of its $4bn in equity. Shares of PacWest have plunged 50 per cent in the past week.

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