Let me tell you something about Wells Fargo (WFC -0.26%) that you probably don't know. While the California-based bank has a lot of things going in its favor, its single most valuable asset is its deposit franchise.
The value of deposits is easy to overlook. Unlike loans, they don't produce income. They aren't sexy and limitlessly profitable as investment banking is purported to be. They don't even have the cache of an otherwise boring wealth management operation. But these things shouldn't fool you.
The vast majority of banks exist to do one thing: arbitrage interest rates. They borrow money cheaply and lend it out dearly. The difference between the former "cost of funds" and the latter "yield on earning assets" is the primary profit engine of all but a select few of America's largest banks.
This is the reason deposits are so valuable, as they're far and away the cheapest source of funds a bank has access to. Take a look at the table on the left, which compares the costs that a typical bank faces for various types of financing.
At first glance, the difference between the rate on interest-bearing deposits and long-term debt might not seem like much. After all, it's only a little more than two percentage points.
But this seemingly insignificant gap takes on new meaning when you consider that a bank like Wells Fargo borrows $1.35 trillion to fund its massive portfolio of assets. At multiples like this, the difference between an interest rate of 2.58% and a rate of 0.16% adds up to $32.6 billion in annual interest expense.
With this in mind, it should be obvious why demand deposits like checking accounts are particularly valuable, as they're effectively free -- that is, excluding the not insignificant costs associated with maintaining and servicing the underlying accounts.
This is the reason that Wells Fargo's deposit franchise is arguably its most valuable asset.
As you can see, Wells Fargo is unmatched among the nation's largest banks in terms of its portfolio of demand deposits. Although JPMorgan Chase (JPM 1.44%) and Bank of America (BAC 1.70%) each have more noninterest-bearing deposits in aggregate, few other banks have access to such a large proportion of essentially free money.
On top of this, we haven't even begun to experience the true value that deposits like these bring to the table. This will become apparent only after the Federal Reserve increases the benchmark Fed Funds Rate, which will boost the yield on Wells Fargo's assets more than it will ratchet up the bank's borrowing costs. The net result will be higher profits and thus presumably larger dividends and share buybacks.
The takeaway for investors is this: Assuming Wells Fargo's management doesn't do something uncharacteristically irresponsible over the next few years, it seems safe to assume that the nation's fourth largest bank by assets will continue growing revenue and delivering phenomenal profits.
