Scale in banking is mostly a funding advantage

It traded at 334.88 this morning, -0.41% on the session. I wrote recently about deposit risk at the regionals. The other side of that trade deserves the same scrutiny.

Where the advantage actually comes from

Not underwriting. Large banks make bad loans too, and in size. The durable advantage is on the liability side: they fund themselves more cheaply than smaller competitors, consistently, through cycles.

Some of that is diversification of the deposit base. Some is the perception, correct or not, that the very largest institutions are less likely to be allowed to fail. That perception is worth basis points on funding, every day, whether or not anyone approves of it.

Why it compounds

A cheaper cost of funds means the same loan, at the same rate, to the same borrower, is more profitable. Which allows either better pricing or better margin, and both widen the gap.

• Deposit beta, which is where the gap is most visible
• Non-interest-bearing share of the base
• Fee income, which is uncorrelated with the funding question and smooths the cycle
• Capital ratios, which set how much of the advantage can be deployed

Where I stand

Long, on the funding advantage rather than on any view about credit. Credit will deteriorate at some point in the cycle, here as everywhere. The funding gap is what determines who is buying assets when it does.

In a downturn the cheapest funded balance sheet is not the safest one. It is the one doing the shopping.

The risk

Deposit competition narrowing the gap, whether from regionals paying up or from money market alternatives pulling balances out of the system entirely. The second is the more interesting threat and gets discussed the least.