Photo: flickr / BurningQuestion
BofA analysts Priya Misra and Brian Smedley have issued a warning in a recent note to clients about another “cliff” facing markets at the end of the year: the “$1.6 trillion deposit cliff” the U.S. banking system faces when special FDIC insurance provisions expire on December 31, 2012.When that happens, according to Misra and Smedley, it could “cause dislocations within the banking system” and send short-term interest rates on Treasuries negative while simultaneously increasing the funding costs banks face.
Here’s the story: the FDIC currently offers unlimited insurance on noninterest-bearing deposits at banks it services.
The unlimited insurance is a policy measure taken in response to the 2008 financial crisis, when banks were having trouble securing funding. Then, in 2010, Dodd-Frank legislation extended the unlimited insurance provisions through the end of 2012.
It’s been a boon for the banking system, which has been able to count on deposit growth as a key source of funding while it deleverages–in lieu of more expensive funding sources like interbank borrowing (indeed, Misra and Smedley point out that all sorts of other funding sources like long-term debt, fed funds, and repo instruments, among others, have decreased by a whopping $1.28 trillion since 2008).
Deposits in these insured accounts have been growing at a decent clip, the dip in the first quarter of this year notwithstanding:
Photo: BofA Merrill Lynch
Furthermore, the deposit growth has forced interest rates down across the board as banks’ holdings of cash and securities have grown.
The depositors contributing to this growth in noninterest-bearing accounts over the past few years are the corporations holding record amounts of cash on their balance sheets and needing a place to park it.
So, what happens when the unlimited insurance provision expires at the end of the year? Misra and Smedley write that, given they expect lawmakers to let it expire, “depositors will be forced to choose between moving their cash elsewhere and accepting that their deposits will be converted from government credit risk to unsecured bank credit risk.”
And that probably means depositors plunge that cash into money-market funds that invest in short-term Treasury bills, according to the BofA analysts. This could cause short-term interest rates to head lower–even into negative territory–given the amount of money on the line.
In addition, if depositors take their cash when deposit insurance expires, Misra and Smedley say that “the bank seeing a net outflow of deposits may respond by replacing the lost funding by issuing non-deposit liabilities, by reducing its cash holdings, or by shrinking its securities portfolio.”
That’s relevant because banks have been a growing source of demand for longer-term fixed-income securities as deposits have surged (BofA says 66 per cent of banks’ current holdings mature over three years from now). If they become sellers of those securities, interest rates could rise and banks would then be faced with higher costs for long-term funding.
Unfortunately, higher costs for long-term funding usually don’t usually translate ceteris paribus into higher economic growth.
Meanwhile, savers in the U.S. will finally get to pay for a safe place to put their cash thanks to negative interest rates.
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