Too much of a good thing? Banks mull over excess deposits

Ask the average person to describe what a bank does, and there’s a good chance they’ll say: “take in deposits and issue loans”. They’d be right – but only under certain circumstances.

These days there are times when banks don’t want to take in deposits at all. Indeed, as the world economy starts to emerge from lockdown, certain lenders are actively trying to drive down the deposit balances they built up over the darkest days of the Covid-19 pandemic.

Why? Three letters: LCR. That stands for ‘liquidity coverage ratio’, a standard implemented by the Basel Committee to prevent bank runs. Under this rule, banks must hold a quantity of high-quality liquid assets (HQLAs) at least equal in value to 30 days of projected net cash outflows. The idea was this would allow a bank to weather a market panic without regulatory intervention.

The LCR assigns specific run-off rates to different categories of funding, including deposits. The higher the run-off rate, the more that type of funding is projected to bolt out the door over that 30-day window. This incentivises banks to limit their use of high run-off funding.

However, over the course of the coronavirus crisis, banks were helpless to prevent one category of high run-off funding from increasing dramatically: non-operational deposits. This is the spare cash institutions and corporates place with banks in excess of the amount they need to service their day-to-day needs.

It’s considered a more flighty kind of funding than most. Take a look at Barclays’ most recent LCR disclosure. Its non-operational deposits had a run-off factor of 58% in the fourth quarter, compared with an operational deposit run-off factor of just 24%.

When the pandemic hit, firms liquidated assets to bolster their cash buffers. This wasn’t money they were planning on spending. The extra cash was just insurance against an extended Covid-induced depression. As such, they served to pump up banks’ non-operational deposits. At Goldman Sachs, JP Morgan and Bank of America, non-operational deposits increased 43%, 49% and 64% over 2020, respectively. At HSBC, Barclays and NatWest: 17%, 19% and 32%.

Over the course of the coronavirus crisis, banks were helpless to prevent one category of high run-off funding from increasing dramatically: non-operational deposits

This tsunami of cash did little to erode banks’ LCRs last year, largely because their holdings of HQLAs piled up, too. But the status quo won’t hold for long. Banks don’t want to be holding huge amounts of low-yielding government bonds and cash reserves over the long term, as doing so will harm their net interest margins. Therefore it’s likely at least some will try to shrink their HQLA portfolios this year and beyond. Barclays is already on the case. Over Q4, it said it cut HQLAs to “manage down surplus liquidity”. This caused its LCR to drop to 162% at end-December from 181% three months prior.

To prevent their LCRs falling too far and too fast as they rejig their liquidity portfolios, banks will likely attempt to pare down non-operational deposits this year, perhaps by encouraging clients to shift their idle cash into money market funds. This may be easier said than done, however. In the US, these funds are under heightened scrutiny after coming under intense pressure during the Covid market rout. Term deposits may be another option, but unless banks can offer attractive rates, it’s doubtful clients will sacrifice the on-demand liquidity they currently enjoy.

This may lead some enterprising banks to cook up new structured deposits, offering clients greater upside in exchange for reduced liquidity and a little risk. These may tempt less risk-averse clients into shedding their non-operational deposits, but it’s no guarantee. Furthermore, if these structured products perform poorly, the banks will have exchanged the problem of excess deposits for excessively angry clients.