Banks' easy profits are about to end
NII peak as funding costs reprice
The fourth-quarter earnings season for America’s largest commercial banks brought a deluge of record headline profits, powered by an immaculate expansion in net interest income (NII). JPMorgan Chase, Bank of America, and Wells Fargo rode the Federal Reserve’s aggressive rate hikes to historic interest margins, earning billions simply by lending out deposits at 4.5 per cent while paying depositors near-zero rates. But as JPMorgan’s cautious 2023 NII guidance of $73 billion demonstrated, bank management teams understand that the golden age of frictionless deposit capture has reached its peak. The era of the zero-cost deposit is dead, and the battle for liquidity is about to compress bank profitability.
The mechanical driver of the banking sector’s 2022 windfall was a phenomenon known as "deposit beta lag." In the initial phase of a tightening cycle, retail and commercial depositors are notoriously slow to move cash out of standard checking accounts.
The Deposit Beta Catch-Up
Banks swiftly repriced floating-rate commercial loans and credit cards to prevailing benchmarks, while keeping deposit remuneration anchored near zero, generating an unprecedented margin windfall.
However, once short-term Treasury bills and money market funds cross the 4.5 per cent threshold, retail lethargy evaporates. Depositors are staging a quiet digital bank run, moving hundreds of billions out of zero-yielding checking accounts into Treasury direct accounts, money market funds, and competitive high-yield certificates of deposit.
Rising Cost of Funds
To prevent deposit flight from draining their reserves, commercial lenders must aggressively hike their deposit betas, paying depositors 3 to 4 per cent simply to retain their existing funding base.
At the same time, credit demand is softening as higher borrowing costs suppress mortgage originations and corporate borrowing. The immaculate interest margins that flattered bank earnings throughout 2022 were an ephemeral front-loaded subsidy; as funding costs reprice to market reality, net interest margins will suffer a structural contraction that leaves equity valuations exposed.