Too many deposits?

The headline of today's Financial Times (4 May 2021) read "Cash-rich US banks move to reduce corporate deposits" (article here for FT subscribers). Why would a bank want to hold lower deposit balances? Is there such a thing as too many deposits? And how does a bank actually reduce deposits?

Customer deposits are essential for banks to lend, though banks do not actually lend out their customers' deposits. They create new money and lend this, holding deposits in reserve against customer withdrawals. Since the money created is immediately placed in the borrower's account, the bank has created a new deposit to fund its loan; but the borrowed funds are likely to be immediately withdrawn from deposits held in reserve (see chapter one of Banking Matters for more on this).

More deposits then mean either more lending is possible, or the bank is at lower risk of a liquidity event (a bank run) since there are more funds held in reserve to pay out against customer withdrawals. So why not take in as many deposits as possible?

Banks make money through maturity transformation, the process of taking in short-term deposits and making long-term loans (such as mortgages and commercial loans). The money that is earned is then allocated to deposit and loan products through internal funds transfer pricing (chapter three of Banking Matters). If a bank has excess deposits, it can place these in its reserve account with the central bank (usually earning low or no income), or it can lend them to other banks in the interbank markets. Whilst this will generate some revenue, margins are low. This means that banks either need to commit funds long term to low returning assets, or to place them in short term assets at even lower returns.

Furthermore, deposits are often associated with transactional accounts. Such accounts are expensive to maintain as customer requests must be serviced, payments cleared and settled, accounts reconciled etc. Where deposit accounts are not transactional (longer-term savings accounts such as time and call deposits), customers must usually be compensated for their loss of liquidity, resulting in higher deposit interest rates; and increased costs for banks.

Prudential regulation (chapter four of Banking Matters) provides a further disincentive to hold excess deposits. The leverage ratio introduced under the third Basel Accords ("Basel III") supplements the risk-based capital adequacy ratio with an additional requirement to hold a minimum level of capital against all assets, regardless of their assessed riskiness. Deposits held in low yielding interbank loans incur the same leverage constraint as those deployed in high yielding (and risky) consumer loans.

A large portion of banks' regulatory capital is required to be held in the form of expensive shareholders' equity. As a result, banks with large excess deposit positions must hold expensive capital against these, further depressing returns.

Excess deposits held by a bank therefore result in increased costs and lower returns. At the same time, the level of reserves needed to mitigate the risk of liquidity events is often considered to be addressed by a bank maintaining at least the regulatory minimum Liquidity Coverage Ratio; in other words, holding sufficient liquid assets to meet anticipated customer withdrawals over 30 days in a stress scenario (chapter four of Banking Matters). Any additional deposits over and above this level provide little additional risk management benefit, but continue to depress returns.

As a result, banks try to avoid holding large excess deposit positions; by reducing their deposit interest rates, by increasing their lending, or by encouraging their customers to place their money in investment funds.

Since the financial crisis in 2008, interest rates have been extremely low, with many deposits paying zero interest. Banks wanting to reduce deposit balances through pricing would therefore have to move to charging for deposits, either through account fees or through negative interest rates. The potential consequences of these actions are not well understood and could lead to much larger deposit withdrawals than intended. Banks have experimented with negative rates for very large professional deposits, but have been generally reluctant to extend this further, ruling it out as an effective strategy to reduce deposits.

A bank's lending needs to earn a sufficiently high interest rate to cover its cost of funding, its operational costs, and any credit losses it may incur. At the same time, a borrowing customer must balance the cost of financing a project with the return they expect to earn on it. As the cost of borrowing rises, the number of projects that remain feasible falls off, with only the more risky endeavours (and the fraudsters with no intention of repaying) remaining, resulting in higher credit losses on a portfolio of lending.

A bank seeking to expand its lending must either take on a larger share of new financing than other banks, or must entice other banks' customers to refinance their borrowings with it. This means either offering a lower cost of borrowing or accepting a higher level of risk for a given borrowing cost. Either way, this reduces the profitability of the bank's lending, and is likely to be further constrained by the bank's risk appetite (chapter five of Banking Matters).

Once profitability falls below a target threshold, or risk appetite constraints become binding, a bank is no longer in a position to expand its lending further. It may however still retain a significant deposit excess (particularly if it is risk averse relative to competition, or if it is seen by depositors as a particularly safe haven for their money).

The remaining option for a bank with excess deposits is to convince its deposit customers of the benefit of placing funds in investment products rather than holding them in deposit accounts. To this end, many banks have launched wealth management business lines to offer investment products to their retail customers, and increased their offering of money market and liquidity funds (chapter seven of Banking Matters) to their corporate customers. This was the subject of the FT article.

Many customers are however uncomfortable with the risks to their capital associated with investment products. This means that until interest rates rise, excess deposits are likely to be a fact of life for many banks.

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