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Lots has been written about the vast bond hoard accumulated by US banks, the massive unrealised losses inflicted on those portfolios as interest rates rose, and the carnage this caused for weaker lenders.

This month’s bond rally will have improved things, but here is a chart from Apollo’s latest US bank outlook showing the damage.



Behind all this is a story of deposits, in particular the $4.2tn worth of "non-interest-bearing" deposits in the US banking system, according to the Federal Reserve. The four biggest banks alone hold about $1.8tn of deposits that pay zero interest. If that paid the roughly 5 per cent current level of interest rates it would amount to $90bn per year.

Customers accepting this is the secret behind banks’ ability to maintain underwater securities portfolios. This is because shareholders expect banks to earn significantly more on their assets than they pay out on their liabilities, to cushion shareholders from actual, realised losses.

Let’s consider Bank of America which has $670bn of securities with $132bn of unrealised losses.

If you divide a bank’s interest income by assets, and interest expense by liabilities, you get a yield. At BofA, loans to consumers and companies earned a yield of 5.4 per cent in the first nine months of 2023, but this gets dragged down by the lower-yielding securities portfolio, giving a net yield on assets of 4.6 per cent. On the liability side, the yield is 3.4 per cent, so a slender 1.2 per cent difference.

Fortunately for BofA, if you include its $564bn of zero-cost deposits, the difference nearly doubles to 2.1 per cent. And it’s a similar story at other US banks.

Wells Fargo says its net interest spread is 3.1 per cent, but it would be 2.39 per cent without the non-interest liabilities, of which $383bn are deposits. JPMorgan’s interest spread would be 2 per cent instead of 2.8 per cent if its $674bn of non-interest deposits suddenly disappeared. For all US banks the average spread is 3.28 per cent according to the Federal Deposit Insurance Corporation.

(Note to bank geeks: we are not using the more commonly quoted net interest margin measure because this uses earning assets as a denominator, which prevents us from exploring non-interest deposit counterfactuals).

To any objection that we are pointing to a hypothetical situation where zero-cost deposits evaporate, remember Silicon Valley Bank and First Republic Bank. Before they failed, both banks reported losses on securities portfolios, which caused a haemorrhage of deposits and plunging net interest income as zero or low-interest sources of funding disappeared.

Of course, BofA and its fellow giants are systemically important, "too big to fail" institutions. Shouldn’t that reassure depositors who might otherwise be alarmed by the unrealised securities losses?

Perhaps it does, but these banks have lost a lot of non-interest deposits in the past year or so, as depositors steadily hunt for better returns for their deposits. Leading the pack is BofA with a 30 per cent decline in non-interest rate deposits. Putting this into perspective, that’s $50bn of Bank of America’s zero-cost funding having to be replaced with more expensive liabilities every quarter.



In calls with investors, BofA says this is a race it is winning because yields on its assets are getting juicier. About $15bn of held-to-maturity assets mature every quarter and get replaced with short-term Treasury paper paying about 5 per cent interest. Commercial and consumer loans are being refinanced at even higher rates. However, this strategy only works if the zero-interest deposit flight slows down.

Who are these people still happy to earn nothing on their bank deposits? In a third-quarter investor presentation, BofA gives us some idea.

About $348bn of the $564bn are retail deposits, mostly checking accounts where consumers accept zero interest as part of a trade-off against fees and a demand for services. In common with other consumer-facing banks, this is BofA’s stickiest, and hence strongest segment.

Surprisingly, corporate clients account for $183bn, for whom technology exists that enables treasurers to squeeze a return out of every drop of company cash. A CFO at a large US company says that treasurers "aren’t paying attention" if they accept zero returns on that cash. But here they are, propping up Bank of America’s balance sheet along with Joe and Jill Public.

Even after SVB and FRB, there’s little regulatory threat. The Federal Reserve is more focused on its "Basel endgame" with tweaks to capital rules. All we have is the FDIC imposing a "special assessment" on uninsured deposits. For BofA’s $1.4tn of uninsured deposits, that amounts to a fee of $1.9bn. Let’s hope that it never needs to be tested.