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How Are the Large Banks Deploying All of Their Excess Liquidity?

Deposits have flooded into the banking system this year as the coronavirus pandemic has resulted in a wave of stimulus initiatives, increased the personal savings rate, and pushed money out of the markets, all of which has found its way into bank accounts. This has created a lot of excess liquidity at banks, but few opportunities to deploy the excess liquidity. Banks are now trying to determine the best strategy forward, and are taking different paths.

To invest in securities or not?

Banks make a good amount of their money by gathering deposits and lending them out at a higher rate than what they paid for them, a source of income known as net interest income. When banks are funding loans with cheap deposits, that's a good thing. But right now, while the deposits have flooded into the banking system, the pandemic has curtailed the demand for loans. This is particularly true on the commercial side, which typically offers the largest interest payments on loans.

Image source: JPMorgan Chase.

To make matters worse, the low-rate environment has dropped the interest rates that banks are receiving on a lot of their current loans, which hurts their net interest income as well. A low-rate environment usually encourages businesses and consumers to borrow more because they can pay less back in interest. Banks combat the low-rate environment by lending more to offset the smaller spreads, but with the loan activity simply not there, banks' margins are in trouble.

One alternative to lending is to take the excess liquidity and invest in safe government-backed U.S. treasuries or mortgage-backed securities, which will produce some yield and bolster net interest income. That's the route that Bank of America (NYSE: BAC) has decided to take. The bank saw its total debt securities between the second and third quarter of the year rise by about $113 billion, reverting the amount from its cash and repurchase agreement into its securities folder. Bank of America CFO Paul Donofrio said the bank has about another $100 billion of "firepower" left and is very likely to move at least some of it into securities in the fourth quarter to protect net interest income.

JPMorgan Chase (NYSE: JPM) appeared to be embracing this theme in the first half of the year, adding roughly $160 billion to its securities portfolio between the end of 2019 and the end of the second quarter of this year. But the bank then decreased its securities portfolio by $27 billion between the end of the second and the end of the third quarters of this year, and doesn't plan to add to its securities folder in the near term either.

On the company's recent earnings call, JPMorgan Chase CEO Jamie Dimon said:

I just want to say that we're not going to do anything to protect the NII [net interest income]. We have $300 billion of cash we can invest today, and that becomes $400 billion. We're not going to invest it in stuff making 50, 60, or 70 basis points [70 bps = 0.70%], so we get to see a teeny little bit more of NII. But we're going to make long-term decisions for the company.

What Dimon is saying is that the return on securities right now is so low that he doesn't see it as a worthwhile gamble. If the bank locks into some five- or 10-year securities and then interest rates rise before these mature, the bank will lose money on these investments. Dimon also told analysts on the call that he thinks it's a bad idea for them to assume interest rates will stay this low forever.

Wells Fargo (NYSE: WFC) seemed to agree with JPMorgan. The bank only increased its total securities folder by about $4 billion between the end of the second quarter and the end of the third quarter, and the total folder is down since the beginning of the year. "We certainly could redeploy tens of billions of dollars into MBS [mortgage-backed securities] or probably even more into similar-duration treasuries," Wells Fargo CFO John Shrewsberry said on the bank's recent earnings call. "But I think, as you heard from at least one of our competitors, really loading up at these levels and locking into both duration and/or negative convexity doesn't seem like a great trade-off."

What do the varying strategies mean?

It's not unreasonable to see where both banks are coming from. JPMorgan has seen more of its revenue come from non-interest income sources such as investment banking, and therefore is not as reliant on net interest income as Bank of America. Additionally, Bank of America just missed hitting estimated revenue targets in the third quarter and is more of a commercial loan player. Therefore it is probably more worried about net interest income, as the commercial sector has seen the weakest loan demand during the pandemic. Ultimately, the push into more securities may help boost Bank of America's net interest income in the fourth quarter, or at least prevent it from falling as much as it would. But it doesn't necessarily mean it's a better long-term strategy.

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Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.


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