Wells Fargo's rising deposit costs continue to put a drag on profits

Wells Fargo was supposed to be a major beneficiary of higher interest rates, but depositors seeking more bang for their buck and soft loan demand from business customers combined to to pinch profits in the second quarter.

The bank's stock price fell 6% in mid-afternoon trading Friday, as investors absorbed the disappointing news about how much interest income the megabank is raking in.

High borrowing costs helped lead to "tepid" loan demand from businesses, said CEO Charlie Scharf, putting a lid on how much interest the bank can collect. All the while, the $1.9 trillion-asset company had to shell out more in interest to keep depositors happy, since they can find higher interest rates elsewhere.

The two factors caused Wells Fargo's net interest income — the difference between its interest revenues and its interest expenses — to fall to just under $12 billion for the first time since the Federal Reserve started raising rates in 2022.

"They're still having to pay more to their deposit customers," said Kyle Sanders, senior equity research analyst at Edward Jones. "Until the Fed cuts, that's going to continue to happen."

Investors' negative reaction on Friday grew out of their expectation that Wells Fargo might upgrade its net interest income guidance for the year, Sanders said. The bank's balance sheet came into the rate hike cycle better positioned for higher rates than some other banks. Its consumer-heavy deposit base fueled hopes that less-savvy customers wouldn't notice rates were rising.

But like others in the industry, Sanders said Wells has "consistently underestimated" the size of increases in its deposit costs. While rising interest expenses have been a bigger pain for regional banks, megabanks such as Wells and JPMorgan Chase have also felt the pinch in recent months.

While Wells stuck to its forecast that net interest income will drop by 7% to 9% this year, the bank also said that it anticipates the metric will land at the higher end of that range.

Even so, Sanders said the stock-price decline on Friday seems "a little bit overdone." He and other analysts pointed to strong growth in the company's revamped credit card business and its fee-driving investment banking business — two areas that CEO Charlie Scharf has built up during his nearly five-year tenure.

Piper Sandler analyst Scott Siefers wrote in a note to clients that the initial pressure on the bank's stock price Friday may fade "as better fees may overwhelm the higher cost guide."

Overall, the company's profits rose to $4.9 billion between April and June, up from $4.6 billion in the first quarter. Higher fee revenues and Scharf's campaign to trim noninterest expenses — the bank's employee headcount is down 11,000 compared to last year — helped reduce the drag from lower interest income.

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The higher interest expenses were partly due to depositors' "continued migration into higher-yielding alternatives," Mike Santomassimo, Wells Fargo's chief financial officer, told reporters Friday. Rather than keeping their cash in low-paying checking accounts, consumers have shifted toward higher-yielding savings accounts or certificates of deposit.

However, the pace of that migration "has slowed and continues to slow," Santomassimo said. Interest expenses climbed 3.3% during the quarter, compared with a 5.4% increase in the first quarter and a 12% jump in the fourth quarter of 2023.

One driver of the most recent increase: Wells Fargo bumped up the interest it pays on deposits in customers' wealth and investment management accounts, a change that will cost the bank $350 million this year.

There was one silver lining to the higher rates the San Francisco-based bank paid on deposits. Wells grew deposits "in every line of business for the first time in a long time," Santomassimo said. The pricing for corporate deposits is competitive and thus adds to interest expense pressures, he noted.

But the deposits are "going to be very valuable over a long period of time, particularly as rates start to come back down," Santomassimo said.