Bank of England Report Says Competition on For Consumer Deposits

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A mid-year report from the Bank of England analyzes the fall of the banking system and says that in the future banks must return to consumer deposits for funding. The report is an interesting overview of what has happened in the banking system.

The Bank of England today released the October 28 Financial Stability Report which paints a grim picture of the UK and global financial system.  While the report focuses on the UK, its analysis and insights are valauble for the US as well.

While the reports says that the banking system has somewhat stabilized, significant risks remain.  These include:

Hedge Funds

The report says:

"Recently, hedge funds have also experienced additional funding pressures due to redemption requests and a risk is that these could increase. Redemptions tend to increase following a period of weak returns. In 2008 Q3, hedge funds had one of their worst quarters on record, losing a little over 10% on average (Chart 5.6). Bank contacts report that redemption requests have been high in particular from funds of hedge funds (FoHFs) in the light of their own redemption requests. Hedge funds generally operate ‘gates’ that place an upper limit on aggregate redemptions in any given quarter. A risk for FoHFs is that hedge fund gates prevent them securing the liquidity that they need to meet redemption requests. FoHFs often have liquidity lines with banks on which they could draw in such circumstances. This would transfer the need for liquidity from FoHFs to banks. Hedge fund liquidity needs may help to explain sales of relatively liquid securities such as developed-country and emerging market equities, the prices of which have fallen sharply in September and October."

In plain English, investors are pulling their money out of hedge funds.  Many hedge funds are not liquid but have bank lines which they can use to meet investor requests to be cashed out.  This puts more of a strain on banks because they must pay out the funds.  In addition, the selling we've seen in emerging markets may be hedge funds selling stock to meet redemptions.

No one seems to think we're at the end of hedge fund pressure. 

Insurance Companies

Significant risks also remain with insurance companies:

"As long-term investors, insurance companies tend to hold a significant proportion of their assets in equities and corporate bonds. The marked decline in the value of these securities in 2008 has generated capital losses for some UK insurance companies, which is reflected in rising CDS spreads and falling equity prices for the sector (Chart 5.7). Unlike banks and hedge funds, however, insurance companies generally do not employ much leverage and have long-term liabilities. So insurance companies seem relatively well placed to avoid liquidity difficulties. Risks could arise, however, if the value of insurance companies’ investments were to fall below regulatory capital requirements. This was an issue in the bear market of 2003, but regulatory reforms introduced in 2004 have reduced the likelihood of this risk by using a more risk-based capital requirement with countercyclical resilience testing. A second risk is that credit ratings of insurance companies could be downgraded. Counterparts to any derivatives trades would then increase margin requirements, increasing the liquidity needs of the insurance sector."

The BofE seems less concerned about insurance companies. 

Solution

Banks are increasingly relying on short term funding to meet their liquidity needs.  This creates risk because if the funding dries up, they will not be able to roll their debt over, resulting in default.  One of the main solutions the BofE sees to this problem is a return to customer deposits.   The Bank writes:

"Over the medium term, banks can reduce vulnerability to rollover risk by financing a greater proportion of customer lending through customer deposits. Such adjustment would result in a narrowing of the customer funding gap. But banks’ willingness to raise customer deposits will be constrained by cost. In the United Kingdom, increased competition for customer deposits has pushed up the cost of such funding."

And there you have it.  The explanation for why deposit rates in the United States have not fallen as far or as fast as the drop in Treasuries and the Fed Funds rate.  Your cash is a valuable, steady source of funding for banks. 

And it will only become more valuable over time.  Don't part with it easy and make sure you are getting the best rate on your savings or money market accounts, or CDs.

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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