After a month of uncertainty, Barclays warned that a “second wave” of deposit outflows is increasingly likely, a sign that the latest banking crisis is far from over.
The collapse of Silicon Valley Bank (SVB) and Signature Bank forced federal regulators to rush to backstop the banking system, which calmed market fears in the short term after many customers pulled billions out of their deposits.
Meanwhile, another wave of bank runs is expected to hit the system, as “sleepy” customers begin to wake up to the existence of higher interest rates available to them in money-market funds, according to Barclays strategist Joseph Abate.
“While market psychology is still fragile, our sense is that deposit outflows from small to large banks will fade as depositors recognize they can access and transfer their balances without any hitches,” Abate wrote.
“Until this week, depositors appear to have paid little attention to the unsecured risk they faced with balances above the insurance cap. And they seem to have largely ignored the low interest rate paid on their deposits.”
The Barclays strategist also noted that their are two distinct waves of deposit outflows could put pressure on bank balance sheets.
Bank Deposits Expected to Get Hit With a Second Wave of Withdrawals
Bank deposits are in the midst of a two-stage shift in which deposits were pulled from smaller banks into larger institutions due to “solvency concerns” during the first bank run, said Abate.
He believes that the first stage may be nearly over, as concerns about bank solvency and deposit access have eased with the establishment of the Federal Reserve’s Bank Term Funding Program (BTFP).
The new BTFP, together with liquidity raised from advances borrowed from the Federal Home Loan Banks (FHLB), “has allowed banks to accumulate very large precautionary liquidity buffers that they can use to meet deposit outflows,” he said.
“We think the first wave of outflows may be nearly over … But the recent tumult regarding deposit safety may have awakened ‘sleepy’ depositors and started what we believe will be a second wave of deposit departures, with balances moving into money market funds,” Abate said.
As solvency fears fade, a second stage is emerging, mainly driven by interest-rate differentials primarily between regional banks, which are unable to match the federal funds rate, he said.
Abate explained that the higher yields in money-market funds have tempted many newly alert depositors to move their savings into their accounts and out of banks.
“Between March 1 and 15, deposits at the largest 25 banks fell about $20 billion, but the decline in balances at small banks has been much steeper. Their deposit loss over the period ($140 billion) is particularly acute, as these banks have been able to retain deposits more successfully than their larger competitors since lift-off.” noted Abate.
“At the same time, money fund balances have risen about $135 billion. Inflows have since continued, with overall balances rising an additional $200 billion—mostly into government-only money funds.”
As depositors discover that they are able to get both higher rates and potentially better safer returns in money markets, banks may now face a double blow.
“Regardless of the precise reasons for lingering in low-yielding deposits thus far, we think that depositors have just awoken to their ability to earn more yield in a money-market fund with potentially less risk. After all, and unlike banks, money funds’ assets are very short, so they are subject to far less interest rate risk in a Fed tightening cycle,” he wrote.
Fed Policy Rates Begin to Have an Effect on Deposits
Abate had earlier spoken with Bloomberg about the low interest rates paid on deposits in a February podcast prior to failure of SVB.
He described back then the so-called deposit betas (the sensitivity of rates paid to depositors relative to Fed policy rates), which historically tend to be low during the early stages of a rate-hiking cycle.
Depositors normally fail to take the initiative to seek out higher rates at first, so banks take advantage of the power of their franchise to gain even larger net interest margins.
Over time though, as the cycle drags on, the banks gradually start passing on higher rates in order to compete for deposits.
Bloomberg referred to a Federal Reserve Bank of New York study from last November whose data proved Abate’s point—that the deeper you get into the cycle, the more bank deposit rates will follow along with the fed funds rate.
He explained that the gap between the fed funds rate and that of bank deposits is currently at the wide end of historical spectrum and has since expanded rapidly during this cycle, strongly encouraging depositors to pull their money out.
Barclays Strategist Expect Movement Into Money-Market Funds to Accelerate
Abate also noted that there may have been already a substantial jump into money-market mutual funds under management, but, alternatively, the cycle may just be warming up.
“It is too hard to shift balances or to establish a new relationship with another institution unless there is a large, convincing yield pickup. But some of it could reflect the fact that after 15 years of near-zero rates, depositors are not in the habit of paying much attention to the yield on their cash balances,” Abate said.
He also pointed out that money-fund balances have witnessed about 20 percent in gains during the last four tightening cycles.
Taking this data into account, Abate said that money funds could rise by $1 trillion, adding that the increase in balances is already at around $600 billion and noted that almost half of the increases have occurred since March 10.
The Barclays strategist also believes in an “inattentiveness” threshold, below which investors do not really pay much attention to the returns on their cash holdings, in either banks or money funds.
This allowed the spread between deposit and market rates to widen greatly with little change in money-fund balances.
However, based on past cycles, once a spread approaches 200 basis points, liquidity will start to move into money funds at an accelerated pace, much to the detriment of smaller banks, which are unable to match money-market rates.
This would quickly gather momentum, causing money-fund balances to rapidly increase by several hundred billion dollars.
“We think the inattentiveness threshold has been reached, and the second wave of deposit outflows has begun, and we expect banks to compete more aggressively for deposits,” he concluded.