The US banking industry took action to increase liquidity in the first quarter after sharp deposit outflows led to two of the largest bank failures in history.

As total assets across the sector increased for the first time in four quarters, banks altered their balance sheets to plug funding holes and reflect a more defensive posture, S&P Global Market Intelligence data shows.

Funding transformation

Deposit runoff accelerated in the first quarter. Total deposits declined for the fourth straight quarter, reaching a decade-high drawdown of 2.5% on a linked-quarter basis. Among the banks with at least $20 billion in total assets at March 31, the biggest loser was San Francisco-based First Republic Bank, which was seized by regulators May 1, with substantially all of the deposits and assets acquired by JPMorgan Chase & Co. unit JPMorgan Chase Bank NA. Even when including a $30 billion deposit infusion from large US banks, First Republic shed 40.8% of its deposit base in the quarter.

The aggregate deposit mix also shifted during the first quarter. Non-brokered deposits dipped 3.4% after two consecutive 1.6% quarterly declines in the second half of 2022. Aside from First Republic, the regional banks that experienced significant deposit outflows included Beverly Hills, Calif.-based PacWest Bancorp unit Pacific Western Bank and Phoenix-based Western Alliance Bancorp. unit Western Alliance Bank. Pacific Western saw about one-quarter of its non-brokered deposits leave, while Western Alliance Bank lost 19.2%.

To make up for lower-cost deposit attrition, banks leaned heavily on wholesale funding. Brokered deposits were up 15.3% from the end of 2022, representing the third consecutive double-digit percentage increase in a quarter. Banks also tapped myriad debt facilities, including Federal Home Loan Bank advances. Total borrowings surged 31.9% across the industry. Bank of America Corp. unit Bank of America NA's brokered deposits soared in excess of 700%, while its borrowings more than doubled.

Asset transformation

On the other side of the balance sheet, banks sought to bolster cash reserves for greater flexibility, including the capacity to cover uninsured deposits. Aggregate cash and equivalents increased 9.1% from Dec. 31, 2022, representing the first increase since third quarter 2021. Las Vegas-based Beal Bank USA more than tripled its cash and equivalents. As a proportion of total assets, the cash ratio rose to 27.1% as of March 31.

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In the first quarter, the banking industry continued trimming the bloated securities portfolios through sales and ordinary runoffs. Total securities decreased 4.6% quarter over quarter. Banks reduced positions in both available-for-sale and held-to-maturity securities. The net unrealized loss on held-to-maturity securities improved to negative $284.0 billion in the first quarter from negative $340.8 billion at year-end 2022.

Banks reported lower total loans and leases for the first time in two years. The first-quarter reduction was 0.2%. The Senior Loan Officer Opinion Survey on Bank Lending Practices for April 2023 revealed widespread tightening of standards and weaker demand.

Record profitability

Despite pumping the brakes on loan growth, the banking industry recorded another quarter of record profitability in terms of net income and pre-provision net revenue. But those first-quarter records come with an asterisk. The banking unit for Raleigh, NC-based First Citizens BancShares Inc. disclosed a bargain purchase gain of about $10 billion on its failed bank transaction, nearly doubling its tangible common equity. And Hicksville, NY-based New York Community Bancorp Inc.'s banking unit realized a $2 billion gain for its failed bank deal.

Banks also enjoyed a banner quarter of trading profits. Noninterest income from trading spiked 64.3% quarter over quarter to $17.72 billion. The Big Four US banks reported blowout results. JPMorgan Chase Bank and Citibank NA led the way with trading revenues of $8.32 billion and $3.27 billion, respectively.

Margin contraction restrained overall profitability in the first quarter, with the net interest margin on a fully taxable equivalent basis sliding to 3.25% from 3.30% a quarter earlier.

Managing interest rate risk was a much bigger priority than credit risk for the industry in the first quarter. While net charge-offs as a percentage of average loans crept to a two-year high, problem asset ratios declined again. Nonperforming assets and loans 90 days or more past due but still accruing interest as a percentage of total assets was 0.46%, down 12 basis points from Dec. 31, 2022.