Where will bank deposit assets flow given the regulatory challenges banks are facing? That is the question Wells Fargo Securities' short-term market strategist Garret Sloan explores in a special commentary entitled, "It's Not You, It's Me: Finding Investment Alternatives for Bank Deposit Investors." Sloan asks, "Why are banks so flush with deposits?" He explains, "In a somewhat perverse way, since the financial crisis of 2008 and the failure of a number of global banks, bank deposits have grown on an outright basis, and in terms of the proportional share of institutional cash investments. Deposit growth can be attributed to four primary drivers: Lack of business reinvestment has resulted in cash accumulation; Unlimited FDIC insurance encouraged companies to park cash; Attractive ECR relative to money market rates; and, Government support (TARP) and regulatory reform has reduced perceived bank risk." (Note: Bank deposits now have over $7.5 trillion in assets, compared to about $2.7 trillion in MMFs. Since the financial crisis in 2008, bank deposits have grown by over $3 trillion, while MMF assets have declined by about $1 trillion.)
What is changing? Sloan writes, "While the last five years have been a relative safe-haven for deposit-minded investors, a new regulatory framework, coupled with the likelihood of rising rates could cause the competitiveness of bank deposits to significantly diminish relative to other investment opportunities." These reforms including the `Liquidity Coverage Ratio (LCR), which requires U.S. bank holding companies with more than $250 billion in assets to hold enough High Quality Liquid Assets (HQLA) to withstand severe deposit outflows over a 30-day period, he explains.
"At all times a bank's Liquidity Coverage Ratio must be greater than 100 percent. As a result, banks may be more likely to (1) purchase assets that provide the best funding efficiency under the LCR and (2) reduce yields on certain deposit products to compensate for the increased cost of institutional demand deposit offerings. Therefore, banks (as investors) may become more competitive in buying high quality assets, but banks (as deposit takers) may become less competitive when compared to similar money market investment products."
Sloan adds, "The previous discussion is not meant to suggest that banks no longer have a need for deposits, but we clearly expect them to price and structure deposit products to minimize their HQLA impact. That suggests that the downward rate pressure on overnight fully fungible deposits is likely to grow even if the Federal Reserve is slow to raise short-term interest rates."
He continues, "There will likely be significant changes in 2015 with respect to the pricing of institutional deposits. As banks start to tangibly detect the true cost of certain deposits under LCR, it is likely that they will begin having pricing conversations with clients more frequently. In a recent Wall Street Journal article the authors anecdotally mentioned five large money center banks that have already had discussions with "clients, which range from large companies to hedge funds, insurers and smaller banks, that they will begin charging fees on accounts that have been free for big customers." (See Crane Data's Dec. 9, 2014, News, "Big Banks Push Away Deposits, Says WSJ.")
What are the alternatives for short-term investors? One is money market funds. The piece continues, "It has been suggested that the structural changes to money market funds will force assets back into bank deposits. However, we would argue that countervailing regulatory forces from LCR may be just as powerful, especially if a rising rate environment widens the yield differential between deposit products and money market funds from the current 0–10 basis points to higher double digits. In that context, we expect that money market fund balances may not be as significantly impacted and may remain an attractive alternative in both floating-rate and fixed-rate forms. There are still a number of operational elements pertaining to money market funds to be sorted out, yet we see them as the closest cousin to bank deposit products and recommend them as a relatively strong alternative for short-term operating cash balances."
Short-term bond funds won't see the same type of flows as MMFs, Sloan says. "We argue that money market funds and short-term bond funds at the sector level have fundamentally different value propositions and will not be economic substitutes even when prime funds float their net asset values. Flows in short-term bond funds do not generally correlate with money market funds, suggesting that investors do not see the two as economic substitutes either. As such, it is unlikely that investors currently investing in bank deposits would directly shift into a short-term bond funds. In fact, we do not generally see short-term bond funds as suitable for the liquidity requirements of operating cash balances at all. As such, we do not anticipate that traditional corporate cash investors will move a significant amount of cash into short-term bond funds and that they will remain a very small component of overall cash strategies."
However, he continues, "We estimate that direct investments will experience the largest marginal inflows from bank deposit outflows. In this estimate, we assume that deposit yields will lag alternative investment yields based on market and regulatory forces. However, not every fixed income asset class will perform the same in the new investment environment and we highlight how various asset classes may fare. Four forces will likely impact short-term yields going forward: (1) overall fixed income supply, (2) bank demand for government assets, (3) deposit flows out of banks, and (4) outflows from prime funds to government funds."
Sloan concludes, "Wells Fargo Economics anticipates that overall Treasury issuance will likely decline as labor markets improve and overall economic growth accelerates.... Meanwhile, the supply of agency-related assets is expected to continue its downward trajectory for at least the next three years.... As global banks fully phase-in the LCR over the coming years, we anticipate that overall demand for government-related assets will continue to grow, pressuring yields lower than they otherwise would." Further, "To the extent that depositors look to reallocate funds from deposits into direct investments, downward yield pressure on highly-rated short-term securities will increase in both government-related and credit-related asset classes. While we do not expect a wholesale exit out of prime funds and into government funds, we expect at least some movement in that direction. The shift from prime to government funds will strengthen demand for government-related short-term assets, while non-government related assets yields should widen (if only slightly), creating opportunity to outperform."
