Summary: Investors in some of the country’s biggest banks are being warned that they may soon have to offer higher rates to depositors. Such action would cut into the higher profits resulting from the Federal Reserve’s decision to increase interest rates. Connel Fullenkamp, professor of the practice of economics at Duke University, points out that not only would it squeeze bank profits, but it also could cause some to struggle. He outlines the three main forces that could lead to this.
“The first one is the migration of deposits. Deposits are leaving banks for money-market funds and other short-term bond funds that offer juicier rates,” says Connel Fullenkamp, professor of the practice of economics at Duke University. “For example, the Treasury predicts that the real rate on the next set of five-year TIPS to be auctioned off next week will be above 2 percent, meaning that investors will receive a rate of inflation plus 2 percent. That should also lure a significant number of deposits out of banks and into these government bonds.”
“But a migration from short-term to longer-term deposits also is underway within banks, and this will put pressure on profits as well. During the years of ultra-low interest rates, bank deposits shifted away from longer-term time deposits such as CDs, into very short-term deposits since there was almost no reward to depositors for locking their money up for long periods.”
“Now, however, depositors are transferring funds out of their low-rate savings and checking deposits and back into time deposits, which pay much higher interest. If the share of bank deposits going into time deposits returns to its average, this means that banks will have to pay out significantly higher rates on hundreds of billions of their existing deposits.”
“Banks may be willing to let a large share of deposits leave, since there was a big increase in bank deposits during the pandemic. During that period, many banks had more deposits coming in than they knew what to do with. But there’s a limit to the total deposit outflows that banks will be willing to tolerate since many of them invested their excess deposits into Treasury bonds.”
“As we saw in the case of Silicon Valley Bank, the increase in interest rates has lowered the value of trillions of dollars of Treasuries sitting on bank balance sheets. The banks won’t have to realize these losses unless they sell the bonds, and this would only happen if too many depositors move their money out of banks. Therefore, many banks will be forced to raise their deposit rates to hold on to deposits that are sunk into Treasuries. This could become very costly.”
“The final way that higher rates will squeeze banks is on the lending side. If banks could simply charge more interest on the loans they make, then they could cover their higher deposit costs and maintain their profit margins. But consumers are balking at paying higher rates on mortgages, car loans and credit cards, and simply aren’t taking out as many loans as they were when rates were lower. The spread of low-cost fintech alternatives to bank loans, like buy-now-pay-later installment lending, is also limiting banks’ ability to increase their lending revenues.”
“It’s hard to say whether these factors will team up to push any banks into distress – it’s fairly clear that Silicon Valley Bank and the others that failed this year were outliers – but disappointing profits for the next few quarters look likely.”
Connel Fullenkamp, professor of the practice of economics at Duke University, specializes in the development and regulation of financial markets. His completed papers have appeared in various leading academic journals, including The Cato Journal, the Journal of Banking and Finance, the Review of Economic Dynamics, and the Review of Economics and Statistics.
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