How Banks Make Money And Why It Can Be A Weakness

How Banks Make Money And Why It Can Be A Weakness
Ben Verschuere - Chief Investment Officer
March 10, 2023

One of the main businesses of a bank is acquiring deposits and using them to make loans or hold interest bearing assets (such as US Treasuries, mortgages, corporate bonds etc…). The bank profit (called net interest margin) is the difference between the rate a bank pays on their deposits and the rate they receive from their  interest bearing assets.

Quick Bank 101: Interest received on an asset - Interest paid on a deposit = Bank profits

As you can see, banks are  constantly incentivized  to maximize profit. As our 101 shows, banks do this  by paying as little as they can on their deposits while generating as much return on their interest bearing assets as they can. This inherently results in  taking on some level of risk (within the guard rails set by regulators).

Things work well for banks when their deposits are growing or stable, but become more complicated when deposits leave.

In order to support outflows, a bank has to sell interest bearing assets to provide the cash required by a depositor who is leaving. Technically there is no issue in selling assets into cash, however this becomes problematic when the bank has incurred a loss on its interest bearing assets. For example, if a depositor put $100 with a bank and the bank bought $100 worth of assets whose price has decreased to $95 dollars, there is a shortfall of $5 when the depositor asks for their cash back.

During the 2019 to 2022 run up in the tech sector, SVB saw a huge inflow in deposits, as lots of startups raised funds and deposited them with SVB. The big mistake made at that time was that SVB used this increase in deposits to buy long dated mortgages at a low yield (1.5%). Last year the Fed quickly hiked rates, and SVB started to incur losses on these mortgages.

SVB deposits grew by 500% between 2019 and 2022. Source: Bloomberg

Quick Bond 101: When interest rates increase, the price of fixed income securities (such as bonds or mortgages) moves lower. Bond holders are locked into the rates they buy in at, so if rates move higher they lose money given they locked a too low rate. For example, if you bought a 10 year mortgage for the price of $100 with a 1.5% yield, if the yield moves by 3% to 4.5% the mortgage price will decrease by 30%. The basic formula to compute bond price change is: 

Bond duration (10year) x Move in interest rate (3%) = Decline of 30%

As yields increase the price of a 10 year US Treasuries goes down.
Source: Bloomberg

It’s not usually an issue for banks to incur losses on their interest bearing asset portfolio because banks use an accounting rule - asset held to maturity - which shelters them for any mark to market risk. But… if bank deposits start leaving, the bank will need to sell its interest bearing assets to accommodate the cash required for its customers' outflows. SVB was forced to sell $20Bn of their mortgages and incurred a loss of close to $2Bn. That $2Bn loss incurred this quarter is equivalent to the entire profit SVB generated last year. This explains why SVB was looking to raise $2B in capital to cover this loss.

As this real life example shows, banks take risks with their customer deposits which, in normal times, might be ok but can also end up hurting their customers in a more difficult environment. As a business you have a choice: You can decide to park your cash at a bank, or instead of letting banks use your deposits to generate their own profit, you can allocate your own business cash to safe, short dated government backed securities away from exposure to banks.

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Ben Verschuere, Co-Founder/CIO
Treasure Financial

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