In 2016, it came to light that employees from the large U.S. bank Wells Fargo (WFC -0.26%) had been opening bank and credit card accounts without the consent of the bank's customers.
The scandal rocked the banking world, and Wells Fargo has never been the same, largely because it's been dealing with fines and litigation while also working to improve its regulatory infrastructure.
Since early 2018, Wells Fargo has also been operating under an asset cap that prevents the bank from growing its balance sheet, which is a key way banks make money -- by increasing interest-earning assets. The asset cap has been one of the main inhibitors of the stock. But heading into 2023, the asset cap may actually prove to be a tailwind for Wells Fargo. Let me explain.
Better positioned on deposits
When the Fed instituted the asset cap in 2018, it limited the bank's assets to $1.95 trillion and tasked the bank with developing a regulatory framework and risk-management programs that would effectively never let an event like the phony-accounts scandal happen again.
Since the pandemic, bank balance sheets have exploded with the Federal Reserve's intense quantitative easing program, which has pumped trillions of dollars of liquidity into the economy up until very recently. The Fed earlier this year began unwinding its balance sheet and letting its bond holdings roll off, which has started to effectively pull liquidity out of the economy and reduce deposits.
U.S. Commercial Banks Deposits data by YCharts.
But the banking system still has healthy levels of liquidity, although it expects total deposits to keep declining as the Fed continues to unwind its balance sheet. Because Wells Fargo couldn't grow its balance sheet in recent years, the bank has been able to be very choosy about the deposits it accepted, Wells Fargo CEO Charlie Scharf said at a recent conference. This was especially true on the wholesale side, where deposits can be more sensitive to interest rates.
Deposit betas outperform
As a result, the bank's deposit betas have outperformed peers. A deposit beta refers to the amount of a rate hike a bank passes on to its deposit customers. When rates rise, customers begin to chase more interest on their deposits. During this time, the type of customers a bank serves, the bank's relationship with those customers, and the stickiness of those deposits become incredibly important.
That's because the main way that banks make money is through net interest income, the profit banks make on loans and securities after funding those assets. Funding costs are a big part of the equation, and the Fed has spent the last six months or so conducting four massive 0.75 percentage point rate hikes. Through the first nine months of the year, the federal funds rate changed from practically zero to about 2.56%.
Meanwhile, Wells Fargo's cost of its interest-bearing deposits went from 4 basis points (1 basis point = 0.01%) to 23 basis points, giving the bank a deposit beta in this time period of roughly 7.4% (19/256), which is terrific. Now, keep in mind there are probably more precise ways to calculate the deposit beta, and there is also a lag in deposit pricing. Make no mistake; deposit betas are going much higher.
Still, Scharf has also said that management is not looking "at using rate in a way to significantly attract new customers. But we are looking at rate as a way to make sure that we're protecting the franchise value inside the company." That means the bank is really only going to use higher interest rates when they feel they need it to keep core customer relationships with good lifetime values.
Right now, it's still kind of a mystery how much deposit betas and pricing are going up in 2023. The good news is that Scharf said he expects the bank's net interest income to be up year over year in 2023, meaning he thinks the bank will be able to control deposit costs somewhat reasonably.
How the asset cap might help next year
If you had asked me a few years ago if I would have thought Wells Fargo's asset cap would have been removed by now, I would have said yes. But with the bank still having many outstanding consent orders, it's really anyone's guess as to when the cap will be removed.
A positive is that the asset cap has really allowed the bank to select great deposit customers since the pandemic started, likely creating stickier relationships. We'll see just how much this pays off next year as deposits across the industry decrease, the battle for deposits becomes more competitive, and deposit pricing rises.
