PERSPECTIVE QUANTITATIVE EASING UNWIND POSES RISKS TO DEPOSIT RELATIONSHIPS
This is the first in a series of Novantas Perspectives that will analyze the implications of the Fed’s move to normalize its balance sheet. This article focuses on deposits; subsequent analyses will dig into other pools of liquidity. Quantitative Easing Unwind Poses Risks to Deposit Relationships
BY BOB WARNOCK
A decade after the Fed took steps to that the rate-seeking, non-operational open market through a process known improve liquidity in a reeling banking commercial deposits are among the as Quantitative Easing (QE). The aim industry, the central bank is now revers- most vulnerable and that banks should was to improve liquidity and stabilize ing course in a move that threatens to take steps to assess their potential expo- debt prices, with the ultimate objective remove what Novantas estimates will be sure. Novantas has instituted a tracking of encouraging loan growth and under- approximately $550 billion of deposits project to assess the impact of the Fed’s lying economic expansion. Over several from circulation. This is just one factor actions, including what banks should iterations of QE, the Federal Reserve among others that will impact the future expect as the process continues and how expanded its balance sheet to ~$4.5T by state of deposit pools, but it is one of they might adjust funding profiles to January 2015 through the purchase of the least well understood. Banks should minimize potential risks. This research UST (~$2.4T) and MBS (~$1.8T). These act now to assess where these deposits is particularly important today as the securities were purchased through the are going to flow from and to determine battle for good, high quality funding issuance of ~2.7T in reserves to par- how to replace the likely attrition from is heating up even before the Fed's ticipating banks, creating an unprec- deposit pools. actions begin to affect rates. edented level of excess reserves and So far, the unwinding process hasn’t consequent deposits — known as QE impacted bank funding profiles, but A BRIEF HISTORY & EXPLANATION OF QE Deposits — that totaled ~$2.4T. market participants are increasingly EFFECTS ON DEPOSITS When the Fed purchased a security wary. And there are implications for Following the onset of the credit crisis, from the market, it did so through a other pools of liquidity as well. In terms the Federal Reserve took the extraordi- clearing bank acting as middleman. The of deposits, however, Novantas believes nary step of purchasing assets in the “middleman” bank bought the security
The Novantas Perspective series provides timely and expert viewpoints on a variety of detailed banking industry subjects. MAY 2018 | 1 PERSPECTIVE QUANTITATIVE EASING UNWIND POSES RISKS TO DEPOSIT RELATIONSHIPS
FIGURE 1: FEDERAL RESERVE BALANCE SHEET
Loans Other Assets
Fed Agency Debt AMBS
UST Securities 1 2 1 2 3 7 1 3 1 2 7 2 1 1 1 1 2 2 2 1 1 1 2 2 2 2 3 1 1 1 1 2 2 2 3 2 2 7 3 1 7 3 1 7 3 1 7 3 1 2 2 2 1 Reserves 1 1 1 1 1 1 1 1 1 1 7 7 7 3 3 3 2 2 2 1 1 1 Axis Title 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 1 2 2 2 2 2 2 2 RRP
Deposits w/FR Banks Currency
Sources: FRED, Novantas Analysis
FIGURE 2: LOANS & DEPOSITS RELATIVE TO FED RESERVES
QEQE Deposits Deposits
ACB QE Reserves
ACB Loans ACB Deposits ACB Total Assets 1 2 2 2 2 3 2 2 2 2 1 7 2 2 11 2 2 2 12 2 2 12 2 2 13 2 2 1 1 2 2 1 2 2 1 3 2 2 1 2 2 17 1 2 2 12 2 2 1 11 2 2 13 1 2 2 1
Sources: H8, Novantas Analysis
The Novantas Perspective series provides timely and expert viewpoints on a variety of detailed banking industry subjects. MAY 2018 | 2 PERSPECTIVE QUANTITATIVE EASING UNWIND POSES RISKS TO DEPOSIT RELATIONSHIPS in the open market and paid for it by growth. But there is now an excess — and in some cases required — to hold crediting the seller’s deposit account supply of reserves, which creates its higher levels of excess reserves. This — a transaction that essentially created own set of problems (see sidebar). was further exacerbated by the Fed pay- new deposits. When the bank then sold ing interest on excess reserves (IOER), the security to the Fed, the central bank IS THERE A LINK BETWEEN RESERVES which removed a portion of the oppor- funded its purchase by issuing a reserve & DEPOSITS? tunity cost that previously existed with to the bank. In the end, that reserve is Many regulators initially hoped that the the accumulation of excess reserves. It the mechanism that (more than) funded increased liquidity and market stabiliza- is estimated that in 2018, assuming the deposit growth. Essentially, most tion provided by QE would jumpstart certain scenarios, that the Fed could of these transactions resulted in the lending activity at banks and eventually pay out ~$40 B in interest expense to creation of non-operational, invest- trickle down into expanding growth. the holders of excess reserves alone! ment deposits that first landed on the Unfortunately, regulatory demands, such Because of the government’s focus balance sheets of clearing banks. The as LCR and HQLA, inadvertently insti- on reserves and lack of emphasis on extra reserves were intended to lead tutionalized the demand for reserves. lending in its regulatory rehash, these to increased lending and economic As a result, banks were incentivized actions led to a temporary distortion and
THE FED’S MANY APPROACHES TO RESERVE DRAINING — REPO EDITION By Bob Warnock
As the Fed unwinds its balance sheet, it will rely on several agreements (ON RRP) to stop rates from falling further — new vehicles that didn’t exist in prior periods to manage inter- essentially a sub-floor to the floor. est rates, including its Repo facility. These actions have the potential to create repercussions through the industry at a This facility helps to maintain interest-rate control by provid- time when funding is already top of mind. ing a reserve-like option to a broad group of both bank and nonbank market participants, enabling them to earn a form Pre-crisis, there were significantly fewer reserves in the bank- of IOER below the official IOER. Similar with banks receiving ing system than today and the Fed didn’t pay interest on bal- IOER, ON RPP participants have no incentive to lend at rates ances that it held. Because of their scarcity, small variations in below the sub floor Fed Funds target rate. supply could produce sharp moves in interest rates. Traders would quickly adjust their positions as the Fed came into the This facility is helping to reshape the liability side of the Fed’s market to buy or sell.This allowed the Fed to conduct monetary balance sheet. Non-bank participants that want to lend to the policy by rationing the supply of reserves. Fed, but can’t directly participate in the IOER program, can earn a similar rate by lending to the Fed via the ON RPP. When Post-crisis, however, the actions taken by the Fed created these non-bank participants place funds with the Fed via this unprecedented excess reserves that altered the traditional program, the new liabilities replace reserves on the Fed’s bal- paradigm. As a result, interest rates have become largely unre- ance sheet and these funds will never be lent out by the Fed sponsive to shifts in the supply of reserves — as demonstrated — essentially trapping them on the Fed’s balance sheet. This by the removal of nearly $800 billion in reserves since 2015. facility, therefore, provides another process of reserve draining for the Fed that doesn’t immediately impact the level of non- This new environment required the Fed to move away from its operating deposits within the market. traditional approach to a floor system that used a combination of abundant reserves (more than what historically would be While the Fed is removing reserves from the banking system, needed) and the payment of interest on those excess reserves it is unlikely that it will remove enough to put substantial (IOER) held at the central bank. In a floor system, the Fed upward pressure on Fed Funds rates in the near term. Instead, Funds rate shouldn’t fall below the IOER because banks don’t it will be a careful balance of removing reserves, paying IOER, have an incentive to lend federal funds to each other at inter- and managing the ON RRP facility. The reserves and IOER est rates below what they could earn by parking their excess portions are designed for banks, while the ON RRP can be reserves with the Fed. used for both banks and non-bank participants. This combina- tion of facilities leads to a more complicated liability position But rates did leak below the IOER (almost certainly because than the Fed has historically managed. If mismanaged during of market inefficiencies) This leaking lead to the creation of its normalization, it could result in significantly more rate another facility that offered overnight reverse repurchase volatility for bank and non-bank companies.
The Novantas Perspective series provides timely and expert viewpoints on a variety of detailed banking industry subjects. MAY 2018 | 3 PERSPECTIVE QUANTITATIVE EASING UNWIND POSES RISKS TO DEPOSIT RELATIONSHIPS decline in the creation of deposits via regulatory change, such as increasing the Fed shouldn’t impact the level of more robust loan growth. As a result, other assets that count towards Level 1 deposits held by foreign banks. the reserve-driven deposit creation HQLA or alterations to IOER by the Fed, On top of that, the Fed has already led to the establishment of large it is premature to assume that the largest drained ~$600 B in reserves since 2015, amounts of non-operational depos- banks will be able to significantly reduce but domestic deposits have increased its for corporations and institutions their reserve holdings. by ~$1.5T. That means the reserve that previously didn’t exist in our drain hasn’t impacted gross deposit monetary system. WHERE WILL THE DECREASE IN RESERVES levels. This is unlikely to continue for SHOW UP? long, however, as the Fed accelerates RESERVES, IN FACT, ARE NEVER LIKELY TO Historically, deposit, loan and GDP its unwind. Initially, the Fed’s unwind RETURN TO PRIOR LEVELS growth held a relatively constant rela- occurred at a slow pace of $10 B per The introduction of regulatory regimes tionship of ~1.00. However, this relation- month in 2017, increased to $20 B per requiring strict liquidity management, ship broke down following the onset month during 1Q18, and will continue such as LCR, have institutionalized the of the credit crisis. While loan growth to accelerate to $50 B per month by the largest banks’ demand for certain assets behaved closer to expectations, deposit end of 2018. As the pace of reserve such as reserves, which count as Level growth defied the relationship due to withdrawal increases, the Fed antici- 1 HQLA. The largest 25 domestic banks QE’s impacts on reserve driven deposit pates this will put upward pressure control approximately $9.5T in assets creation. Novantas estimates that had on the Fed Funds rate. — or ~66% of the total — while the next the historical relationship of deposit While we believe that a majority 75 banks control approximately $5-6T. growth versus GDP growth held, the of the initial reserve-driven deposits Like scale and concentration in assets, market should have ~$1.7-3.6 T less landed on the clearing banks’ balance we should expect similar activity in in deposits since the credit crisis, sheets, after several iterations of QE, reserves at these institutions. Not sur- which coincidently brackets the $2.1 T it is virtually impossible to track the prisingly, this is exactly what is playing increase in excess reserves. whereabouts of the original ~$1.1 T out today. There are several different estimates reserves created. More importantly, Large banks have seen a ~450% of the level of deposits at risk to leave it is difficult to assess whether their increase in reserve levels since the the system. Novantas has approached disappearance from the system — and start of the crisis and their level of the problem by evaluating the relation- the corresponding depletion of depos- reserve as a percent of total assets ship between the ~$2.4T in unexpected its that they created — will put the have increased from 6% to 10%. deposits and the Fed’s issuance of excess banks at risk. Indeed, those deposits Additionally, seven of the top 10 holders reserves. As the Fed unwinds those could have been used for anything of reserves today are GSIBs that must transactions, reserves and deposits will from other types of asset purchases to comply with LCR. Most GSIBs maintain both decline. The question, therefore, payroll. To add to the complexity of the LCR rations well over the 100% regula- is how to identify where those depos- problem, several of the largest clearing tory requirement since they must hold its are being held. The short answer banks have announced plans to reduce enough liquidity at each of their subsid- is in investible corporate balances at their level of non-operational deposits, iaries in order to pass their living will domestic banks (and incidentally not at which means that these deposits have exams. Roughly 65% of the total domes- foreign banks). trickled down into smaller institutions tic reserves are controlled by the largest Novantas has determined that (with lower, or no, LCR and HQLA four domestic banks. nearly 42% (~$0.9T) of excess reserves requirements) that are otherwise Those LCR and HQLA binding con- created by the Fed are controlled by unaware that they could soon vanish straints will come into play as the Fed foreign banks that funded their pur- from the balance sheet. unwinds its balance sheet. Clearly some chases largely with borrowings rather As a starting point to determine of the bank reserves will come out of the than deposits. These banks are largely where the rest of the deposits are system. As the level of excess reserves participating in an arbitrage opportu- held, Novantas has estimated the are removed, it is assumed that banks will nity to collect a richer spread on their level of excess reserves at $430-660B. naturally shift their demand for a source excess reserves than is available for the The estimate is based on a combination of Level 1 HQLA from reserves to other domestic banks due to several external of the Fed’s projected level of ending Level 1 assets such as UST, while alter- factors, including a regulatory report- reserves in 4Q2021, and a bottom’s up ing their mix of liabilities so that fewer ing advantage. The evaluation, based estimate of the GSIB’s HQLA holdings reserves are required. Recent research on filings and Fed data, finds that for- that would remain in reserves post the by the Fed indicates that this trend is eign deposits held domestically actu- Fed’s unwind. At the mid-point, that already under way, especially at modi- ally declined by ~$95B during the QE implies ~1% headwind in YoY growth to fied LCR-compliant institutions. Without period. As a result, any unwinding by deposits in each of the next four years.
The Novantas Perspective series provides timely and expert viewpoints on a variety of detailed banking industry subjects. MAY 2018 | 4 PERSPECTIVE QUANTITATIVE EASING UNWIND POSES RISKS TO DEPOSIT RELATIONSHIPS
FIGURE 3: TODAY'S DEPOSIT COMPOSITION (~$13.2T) TO TOMORROW'S DEPOSIT COMPOSITION (~$12.7)
RETAIL COMMERCIAL RETAIL COMMERCIAL
E R NI
I DA S E R NI DA S
I DA S
I DDA S DA T I DDA S T ~$550 B NI T NI T S
Sources: FDIC, SNL, CDA, Novantas Commercial Deposit Survey, Right Hand Scenario Assumptions: Interest rates continue to rise as projected to 3% by 2019 (St. Louis Fed), Customer deposits will shift out of NIB/ECR DDA and into interest-bearing deposits, (similar to 2007 mix), Customer deposits will shift out of deposits and into other instruments like MMF and direct securities (similar to 1999 levels)
Non-retail deposits have increased THE BIG QUESTION: WHICH INSTITUTIONS Third, consider how the commercial- by ~97% since the start of the crisis WILL BE AFFECTED? deposit book has performed since the versus a ~46% growth in retail deposits. While simplistic in practice, there are implementation of LCR. For example, These fast-growing non-retail deposits a few things that banks can scan for at significant growth in new relationships are the direct result of QE and tied to the surface to determine if they need to can signal a problem because that the issuance of reserves. The pruning of conduct further due diligence on their growth could have been due to non- these non-operational deposits by the funding profile. operational deposit pruning elsewhere clearing banks increases the risk in First, determine what percentage of in the market. liquidity-starved banks that unknow- deposits is retail. The higher, the bet- Once these quick steps are com- ingly accepted the deposits as new ter because retail deposits should be pleted, a bank should have a high-level relationships with open arms. Some stickier in a rising-rate environment. idea of how much of the deposit rela- of these deposits will remain in the Second, of those retail deposits, tionships could be at risk to leave dur- system due to myriad factors, but as we assess the average size of account. ing the unwind. It might not indicate have shown above, a fair amount could The more granular, the better because how they fit into the system at large, but leave the system at some point during it should help insulate the book from it is a solid starting point for building a the unwind. pricing pressures. foundation of knowledge.
Bob Warnock Vice President of Industry Analysis, Chicago [email protected]
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Sources: Federal Reserve, FRED, FDIC, “Domestic Open Market Operations During 2016”, “Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington DC — How Have Banks Been Managing the Composition of High-Quality Liquid Assets”, “Implementing Monetary Policy: Perspective from the Open Market Trading Desk”, Projections for the SOMA Portfolio and Net Income — An Update to Projections Presented in the “Report on Domestic Open Market Operations During 2016”, Novantas Analysis
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