In a development that is of little surprise, banks are shedding deposits. They are not doing that because deposits are not part of the business of banking, since receiving deposits and putting them to work are something that banks prefer to do. Recent regulations, however, are distorting the business of banking and making banks operate in very unbanking ways.
I would point to two regulations in particular. The first comes out of the suite of prudential regulations designed by an international team of bank regulators at Basel, Switzerland. It is called the Liquidity Coverage Ratio (LCR). The LCR is a good idea gone bad. The good idea is that banks should pay close attention to how liquid their sources of funding are, particularly how liquid they might be in times of stress—stress at the bank or for the whole economy. The bad is the effort to develop detailed standards globally to be imposed locally.
The one-size-fits all global design does not fit the U.S. financial system very well (indeed, it is not clear that it fits any specific nation’s financial system very well). For example, the global rules assume that during financial stress people will pull their deposits out of the banking system. Maybe that happened in Europe. U.S. experience has been just the opposite. During the depths of our recent recession and financial crisis depositors saw banks as a safe haven and flooded the treasuries of U.S. banks with more than a trillion dollars in increased deposits.
Nevertheless, under the LCR, U.S. banks are required by regulations to pretend that they will experience a run on deposits, and in perpetual preparation they must invest a mandated portion of those deposits in what are termed “high quality liquid assets” (HQLA). These regulator-favored assets are basically sovereign instruments, such as cash and Treasury debt, with a smattering of top-rated corporate debt (discounted under the LCR rules). The more deposits a bank takes in, the more HQLA—i.e. government securities—it is required to hold. Unfortunately, because of the Federal Reserve’s zero interest rate policy (ZIRP), government securities pay almost nothing in interest.
That is where the next regulatory problem for bank deposits comes in. Global capital rules that originated in Basel require banks to hold capital measured in a variety of ways. One of these is the leverage ratio, a measure that is blind to risk. The leverage ratio—which for U.S. banks is double the Basel standard—requires banks to hold capital equal to a fixed ratio of their assets (loans and other investments), regardless of how risky those assets may be. Every deposit has to be invested in an asset, even if just left in cash (a zero-coupon government security), and therefore it is subject to a capital charge.
Put that all together, and a bank is faced with placing a portion of all deposits in a share of government securities and, regardless of the risk, hold capital against the money. That significantly increases the cost of deposit taking. No surprise, banks are being driven by these and related regulations to shed deposits.
This very unbanklike activity was noted in a recent Wall Street Journal article, by Juliet Chung and Sarah Krouse, “Big Banks to America’s Firms: We Don’t Want Your Cash.” Sad but too true. Banks would like to want the deposits, but that part of basic banking is being crowded out by poorly coordinated regulatory mandates.
There are ways to relieve this problem, such as by expanding what counts as HQLA beyond the prescribed concentration in U.S. Treasuries and other sovereign instruments, and by not counting very low risk investments—such as deposits at the Federal Reserve—for capital purposes, but regulators are currently in denial. No problem here, move along.
And yet the real-world problems and dislocations are starting to build up. There are other new rules as well that interact in unintended but predictably harmful ways (reduced liquidity from the Volcker Rule, excess concentration at swaps clearing facilities, to name a couple others). Unfortunately, unless the deposit-distorting rules and others like them are addressed, there are more non-surprises ahead for our financial system.