WHEN THE FED LIFTS OFF, THIS IS WHAT TO WATCH AT BANKS / THE WALL STREET JOURNAL

When the Fed Lifts Off, This Is What to Watch at Banks

Hot-money deposits could make a rate rise a turbulent time for banks.

By John Carney

 Bank of America is among the banks better positioned to weather a Federal Reserve rate rise, according to Credit Suisse data. Photo: Mark Lennihan/Associated Press


The Federal Reserve’s liftoff may be far more turbulent for banks than many expect. Investors should buckle up.

Bank stocks have taken a beating in recent weeks as investors pared back expectations about the upside to earnings from a rise in interest rates. Less attention, however, has been paid to the liability side of bank balance sheets. As a result, this could produce some surprises for investors in the months to come, especially given Fed officials have been again banging the drum about a rate increase coming this year.

Years of superlow rates have encouraged complacency about the cost of funding. During the era of excess reserves, there was little reward for monitoring a bank’s ability to attract low-cost deposit funding. If anything, banks faced criticism for having “too many” excess reserves.

That is likely to change rapidly when the Fed begins to raise rates. Higher rates could drain deposits from banks, possibly into things like money-market funds or short-term debt.

Thanks to new liquidity rules requiring banks to hold so-called high-quality liquid assets, any the deposit drain shouldn’t be ruinous for large banks. But compliance with the liquidity rules doesn’t mean all the big banks are equally well-equipped to deal with any big moves.

Banks that have more reserves than the deposits they lose should have the easiest time navigating the new environment. They will see both sides of their balance sheets shrink in tandem. This could actually free up capital, allowing the best-positioned banks to raise dividends or buybacks.

But banks whose liquidity positions are more heavily reliant on U.S. Treasurys and mortgage-backed securities will find things more complicated. They may find themselves having to sell these bonds to finance deposit outflows or lend them out in the repurchase market. Preferably, they could also pay more for deposits in the wholesale market to stem the outflow. Regardless, this could mean tighter net interest margins and diminished profits.

So which banks are best positioned? The disclosures from banks make this difficult to assess. Credit Suisse analysts recently suggested comparing the reserve levels of banks to their nontransactional institutional deposits, a rough proxy for the kind of fast-money deposits that are likely to quickly leave banks.

Of the four universal U.S. banks, only J.P. Morgan Chase JPM -0.08 % has more reserves than fast-money deposits, according to Credit Suisse. Wells Fargo WFC 1.13 % ’s reserves liquidity position amounts to nearly 60% of its fast-money deposits, putting it in the next-strongest place. 

Bank of America BAC -0.71 % and Citigroup C 0.04 % are in distant third and fourth places, with each holding reserves equivalent to one-third of their fast-money deposits.

Bank of America’s exposure to this liquidity risk, though, could be diminished by its larger retail deposit base. Retail deposits are thought to be less sensitive to rates and likely to move more gradually.

These account for around 57% of BofA’s overall U.S. deposits, according to Sanford Bernstein. That is far more than J.P. Morgan’s 39%. Whether the stability of retail deposits will be enough to offset the risk from the lower reserve position won’t be clear until after rates rise.

The only thing certain is that banks will soon step into unexplored territory. The odds of one or more banks stumbling over new ground are high.