The Big Idea

Easing an income pinch with wholesale funding

Tom O'Hara, CFA | February 3, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Banks this year should have a hard time repeating the earnings-palooza of 2022 as pandemic-driven cash supply leaves the system and banks need to pay depositors more to stay. The mix of deposits is also shifting toward more expensive interest-bearing deposits. Banks consequently will need to raise more wholesale funds to offset deposit run-off, which may further compress net interest income. But wholesale funding still looks like the most efficient game in town.

Ensuring liquidity and protecting earnings

Bank wholesale funding has jumped by roughly $300 billion since last June (Exhibit 1). That is small amidst banks’ nearly $21 trillion in liabilities, but it is offsetting a decline in core retail deposits. Rising balances at money market funds suggests those deposits are leaving for higher yields away. The competition for cash has started.

Exhibit 1: Wholesale funding has helped offset core deposit runoff

Source: Federal Reserve H.8 as of 1/4/23, Amherst Pierpont Securities

One notable form of wholesale funding on the rise is borrowing from the Fed’s discount window, reaching as much as $9 billion last November. At the beginning of pandemic, the Fed reduced the premium of the discount window over the top end of the fed funds range from 50 bp to 0 bp, ending the historical premium over funds and trying to remove the stigma attached to borrowing at the window. The Fed also extended the maximum term from overnight to 90 days with the option to prepay at any time, providing banks with more flexibility. The New York Fed recently noted recently noted that most of the borrowers are banks with assets less than $3 billion. The NY Fed noted that quantitative tightening has resulted in a disproportionally large cash drain at these smaller banks.

Bank treasury teams will need to deploy the full arsenal of wholesale funding alternatives, including FHLBank borrowings, unsecured debt issuance, securitization and repurchase agreements, all of which will likely be more expensive than deposits.

For our bank tracking group, the median cost of interest-bearing deposits is 0.56%, whereas the median cost of other debt is 3.03% as of the third quarter last year—5.4 times higher. However, interest-bearing deposits account for 58% of the median bank’s funding mix, compared to 10% for other debt, or 5.8 times the amount of other debt. This helps illustrate why seemingly more expensive wholesale funding alternatives continue to be an attractive part of the overall liability mix. A bank that issues new unsecured debt around 5% would see the same dollars of interest expense by increasing their deposit cost by just a few basis points.

Banks can also take advantage of the currently inverted yield curve to issue longer-dated debt. A large regional bank recently issued 3- and 10-year senior debt on the same day, where the spread differential between the two was 70 bp. But given a 40 bp point curve inversion, the bank was able to print a coupon on the 10-year that was only 30 bp higher than the 3-year.

Of course, to enhance net interest income, banks could look to expand the credit box of their loan and securities portfolios, although given the possibility of recession in 2023, the timing might not get a warm reception from investors or regulators. Banks could also shift balance sheet interest rate exposure. Where many banks added duration in the second and third quarters of 2022 to make themselves less asset sensitive, that activity has cooled in recent months. Most banks remain modestly asset sensitive and seem content to hold their rate risk profile constant until a clearer market direction develops.

The background: a rising cost of funds

The marginal impact of wholesale funding varies significantly from bank to bank based on the pricing of deposits. With loans growing at a robust pace, banks are reaching their limits in terms of how much cash they have allowed to run-off and realize they need to start paying their depositors more. This is referred to as ‘beta’—how much of the market increase in rates is passed on to depositors. Betas were very low in the first quarter of 2022 but started to rise in the second quarter after the first Fed hikes in March 2022. For our tracking group, that beta overall was 17% on a cumulative basis in the second quarter. As the Fed continued tightening in the subsequent months, banks were forced to increase rates further, resulting in a third quarter of 2022 cumulative beta of 27% (Exhibit 2).

A bank’s beta is usually a conscious decision made by management based on the amount of excess liquidity a bank has, balanced against net interest income needs. Banks with more excess liquidity were happy to keep their betas lower to allow some deposits to run-off and improve earnings. As the graph shows, there is quite a wide range of outcomes based on the individual bank’s own business model, with some banks still reflecting cumulative betas of 10% or lower in the third quarter of 2022, and others around 50%.

Exhibit 2: Betas on the rise